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What Is Open Interest?
In derivative trading, you may have wondered what is open interest?
It consists of the total number of derivative contracts that are outstanding, like options or futures, that are held by traders at the end of a day. It is a measure of the total activity level in a futures market.
As we all know, trade always has two sides - a seller and a buyer. Let us consider that one contract is sold by a buyer to a seller. Then, it is said that the buyer is long on the deal while the seller is short on that same contract.
In this case, the open interest is 1.
What Is Open Interest?
As we have seen above, this type of interest is the number of outstanding derivatives contracts. The importance of it lies in the fact that it provides an accurate estimate of options trading activity. It indicates whether the flow of money in the options and futures market is increasing or decreasing.
Before we understand the concept entirely, we have to look into options and futures contracts first. The relationship that a buyer has with a seller leads to the creation of one deal. One contract of the underlying asset equals to 100 shares. The agreement is considered to be an open one until it is closed by the counter party. The open interest is an addition of the open contracts.
If a seller and a buyer come together to initiate a contract’s new position, that will result in an increase in the open interest by one deal. In case the buyer and seller exit a contract position in a trade, then there is a decrease by one contract. In case the buyer or seller transfers their current position to another seller or buyer, then there is no change in the status.
An increase signifies that there is an inflow of money in the marketplace. This will result in the continuation of the present trend. A declining open interest means the liquidation of the market and indicates that the prevalent price trend is approaching its end. In this way, it is an indication of any approaching changes in the pattern. To calculate the total for any market, we only need to add up the number of either the buyers or the sellers.
What do changes to open interest indicate?
This type of interest is the total number of contracts and not a total of all transactions. Suppose a trader has five contracts long (sell) and another has five contracts long (buy). After closing the contracts are deducted from the total open interest.
The concept is usually associated with futures and options. In these types of markets, there is a change in the number of contracts every day. It is different from stock trading, where the number of outstanding shares of a company remains fixed after issue.
There is a common misconception about this type of interest- that it has a predictive ability. However, it cannot predict price action. Any movement merely indicates investors’ inclination. It does not guarantee in any way the accuracy of their views or the profitability of their positions.
Open Interest and Volume
This type of interest provides us with one piece of information- the number of contracts that are live and open in the market. Volume is an indicator of the number of trades that were executed on a particular day. For every buy and sell, there is a corresponding increase in size. Suppose on a given day, 250 contracts are bought, and 250 are sold. The day’s volume is 250, not 500.
Volume and open interest seem to be similar in the information they provide, but there are distinct differences. At the beginning of the day, the former count always starts from zero and increases whenever new trade occurs. The increase in volume is always intraday, whereas the latter is not as discrete as volumes. It increases or decreases based on the exit and entry of traders.
Both fluctuate daily; the volume of one day does not influence the size of the next day. But, this is not the case for open interest. Taken separately, both have little use. But these numbers are usually associated with prices and are used by traders to make inferences.
Why is Open Interest Important?
Open interest measures the activity of the market. A lower or zero number indicates that there are no positions opening, or that most of them have been closed. If it’s on the higher side, it demonstrates that numerous contracts are still open, and participants of the market will be keeping a close watch on it.
Open interest also indicates trend strength. Since an increase means additional money and investment flowing into the market, it is usually seen as an indicator of the current market trend gaining momentum and continuing. Technical analysts believe that it can provide a person with valuable insight into the market. If there is a slowing down after a substantial movement in price, this might indicate a nearing of the trend’s end.
Open interest measures the amount of money flowing into the market of options and futures. An upward rise of it indicates new money entering the market, and a fall means that money is flowing out.
Author bio: Maithili Pawar is a financial expert with 5 years of experience in the investment banking field. In her free time, she writes on trading topics. In this, she has given an overview of open interest
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