Open interest (OI) is a vital concept all option traders should understand. OI is always one of the data fields of most option quote displays - along with bid price, ask price. Some traders ignore open interest, but while it may be less important than the option's price, or even current volume, open interest provides important information that must be considered while entering an option position.
What’s the Open Interest?
Buying and Selling make a contract, both market participants’ buyer and seller transacts to make a single contract. The open-interest position represents the increase or decrease in the number of contracts for the particular scrip on the trading day, and it is shown as a positive or negative number.
Generally, an increase in open interest vis-à-vis increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.
Open interest also gives the key information regarding the liquidity of an option trade. When options have large open interest, it means that there are large number of buyers and sellers, and an active secondary market will increase the odds of getting option traded at good prices. So, all other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable price.
There are many rules regarding open interest in respect of option trading, in different publications from different authors. Below you will find a quick review from collections of these rules...
If ask or bid prices are rising and open interest is increasing at a rate faster than its five-year seasonal average, this is a bullish sign. It means more participants are entering the market, involving additional buying, and any purchases are generally aggressive in nature.
High open interest at market tops is a bearish signal if it’s with the sudden drop in price, because this will force many 'weak' buyers/holders to liquidate their positions.
Unusually high or record open interest in a bull market is a danger sign. When a rising trend of open interest begins to reverse, expect a bear trend to get underway.
With rising prices and a decline in open interest at a rate greater than the usual norm is bearish. This market condition develops because of short covering and not fundamental demand is fueling the rising price trend. In these circumstances money is flowing out of the market. Consequently, when the short covering has been done, what follows will be declining prices.
When open-interest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an over hanging top.
Declining prices and the rise in open interest more than the seasonal average indicates that new short positions are being opened. As long as this process continues it is a bearish factor, but once the shorts begin to cover it turns bullish.
Decline in both price and open interest indicates liquidation of positions by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.
The best trade will come consistently in calls with high open interest and liquidity (high volume). Just remember that the market will give a lot of opportunities if there is deep open interest.
That’s all for Open Interest - Invest smartly.
