Explanation of the Term Open Interest
Open interest refers to the total number of outstanding contracts in the futures or options market that have not been closed, settled, or expired. Open interest typically applies to futures and options markets, where contracts exist and change over time—unlike the stock market, where the shares of a company continue to exist after an initial public offering (IPO) has been completed.
Example of Open Interest Creation
| Date | Transaction | Open Interest (O.I) | Explanation |
|---|---|---|---|
| 01/01/16 | A buys 1 lot and B sells 1 lot | 1 | New buy/sell transaction |
| 02/01/16 | C buys 5 lots and D sells 5 lots | 6 | New buy/sell transaction |
| 03/01/16 | A sells 1 lot and D buys 1 lot | 5 | A and D close 1 contract |
| 04/01/16 | E buys 5 lots and C sells 5 lots | 5 | E buys new, C closes |
In every transaction, there must always be a buyer and a seller, and together they create a contract (or lot). Therefore, the total open interest in futures or options markets is calculated based on the contracts created by both sides, not by combining the numbers from both the buyer and the seller.
The open interest can sometimes be confusing as it differs from trading volume (volume). These two terms refer to two different measurements.
For example, if a trader holding 10 lots of long positions sells those 10 lots to someone who then opens a new long position, there is no change in open interest, because no new contracts have been added to the market (a previous holder exits, and a new one enters). However, the sale of 10 lots does increase the trading volume (volume) by 10 lots.
Open interest (O.I) only increases when both a new buyer AND a new seller enter the market and create a new contract.
Importance of Open Interest
Open interest serves as a measure of the flow of capital into the futures or options market. An increase in open interest indicates that new money is entering the market, while a decrease in open interest suggests that money is being withdrawn. The increase in open interest is often interpreted as a bullish signal (indicating upward price movement), while a decrease is seen as a bearish signal (indicating downward price movement).
Open interest is also used as a momentum indicator to gauge the strength of the market trend. When open interest rises, it suggests that additional capital is flowing in, indicating that investors are interested in that market.