Definition and Example of Open Interest
In trading, open interest refers to the number of outstanding contracts for futures or options in a particular market. It serves as an indicator of market strength by showing whether cash is flowing into or out of those specific contracts.
How Open Interest Works
Open interest is calculated by adding all contracts associated with open trades. Then, all contracts associated with closed trades are subtracted. For example, let’s assume three traders (Trader A, Trader B, and Trader C) are all trading in the ES futures market. Their trades may affect open interest in the following way:
- Trader A enters a long position by buying one contract. Open interest increases to 1.
- Trader B enters a long position by buying four contracts. Open interest increases to 5.
- Trader A exits his position by selling one contract. Open interest decreases to 4.
- Trader C enters a short position by selling four contracts. Open interest increases to 8.
Open interest becomes more complex when considering that each trader is buying or selling from another trader who is selling or buying. Sometimes both parties will open trades and increase open interest, while at other times one party will close a trade and the other will open a new trade (which does not affect open interest). Both parties can also close trades (reducing open interest).
What Open Interest Means for Individual Investors
Open interest is often used as a confirming signal for current price movements. However, on its own, it does not provide much information about price action. It shows the number of contracts that are currently in open positions, but it does not tell us who is long or short.
Measure of Strength or Weakness
An increase in open interest indicates that there is strength behind the current price trend as the number of contracts traded increases. In other words, activity is increasing and there is excitement surrounding the movement. A decrease in open interest shows that there is a potential weakness in the current price trend, as traders are closing their positions faster than new traders are opening them.
The Reversal and Sideways Markets
An increase in open interest alongside a price increase suggests that the upward price movement may continue. However, a decrease in open interest alongside a price increase indicates that the upward price movement may be on the verge of reversal.
Open interest is also used to determine whether the market is trending or sideways (consolidating). An increase in open interest shows that the rate of new positions is rising, indicating that the market is being actively traded and is likely to trend. A decrease in open interest shows that the rate of new positions is decreasing, indicating that the market may experience less active trading and is likely to be consolidating.
Word of Caution
Little open interest in an options or futures contract can mean there is no active market for it. Volume also provides this information. However, even if there is a lot of open interest, it does not necessarily mean that the futures or options contract will be traded heavily on a given day. Since open interest reflects open positions, those positions can remain open with low volume, but ultimately, traders want to close their positions.
Sources:
CME Group
Source: https://www.thebalancemoney.com/open-interest-1031298
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