The beautiful thing about the options market is that it's as big or as small as we (the traders) make it. When it comes to open interest, each expiration starts with the same amount of contracts - ZERO.
From here there is no limit to how much the market can grow. There will simply be as many contracts as there are buyers and sellers to support the demand.
A thing of beauty. Enough day dreaming about the markets though, let's get into this.
What Is Open Interest?
Simply put open interest is the open number of contracts that remain for an expiration month. This includes contracts that have not been exercised, offset, or expired.
It's pretty common that beginning traders confuse open interest with volume. As a stock trader, you only really have 1 measure of liquidity and activity which is volume. As an options trader you have to consider both volume AND open interest. The truth is that they are completely different data points.
O.I. Only Increases With New Contracts
When brand new contracts are created, that did not previously exist, option open interest will increase. This means that a new buyer must take a long position and a new seller must take a short position. Together they create 1 new contract in the market.
Open interest can decrease then if both the buyer and the seller close their existing position. In this case the 1 contract that they had between each other would terminate and reduce the market's open interest.
Let's Go Through An Example
What better way to explain what could be a complicated topic than an a great example. First let's assume that we have 5 separate traders labeled A through E.
A decides to buy a contract at the same time that B decides to sell a contract = the result is 1 brand new contract being created.
C later also decides to buy 5 contracts again at the same time that D decides to sell 5 contracts = just like the transaction between A and B, the new agreement creates 5 brand new contracts. Now the total is 6 open contracts.
After 2 days of trading A decides to sell his contract. At the time B is not willing to sell his contract but D is willing to sell 1 of his 5 = this results in a valid transaction and the closing of 1 contract. OI drops to 5.
Finally, trader E comes into the market and decides to buy 5 contracts from C. Trader C already owns the contracts so his sale will help fund the purchase for E = since no new contracts are created, open interest remains the same.
The Only Benefit of Open Interest
In reality the only real benefit I see in open interest is the ability to trade a more active contract. The increased liquidity helps fill orders faster and at smaller bid/ask spreads. And if you've ever traded an illiquid option or stock you know first hand how hard it is to get out of the position (let alone at a decent price).
Some people incorrectly assume that higher open interest means smarter traders - not true. Higher open interest just means that - higher activity and interest in the particular strike. Remember that 1 contract means you have a buyer AND a seller and they both can't be THAT smart.
I Understand O.I., What About Volume?
If you've followed me this far you probably have a real good idea about what open interest is and isn't. Just for the sake of clarity let's make sure you still understand volume as it relates to options trading.
For options, volume is simple the raw number of contracts that have changed hands on the particular day. This is irrelevant of whether a new contract was created or not.
This might explain why you might see large volume of say 10,000 contracts on the day but open interest of just 5,000. Well, that's because some of the contracts that were traded must have been closed out before the end of the day.
Tracking Open Interest
I'm going to leave this question for the comments section below. Most traders think that open interest is always posted live on the quotes tab of your broker platform - but that's incorrect. It's actually posted completely different that you might have thought before.
Take a stab at guessing when and more importantly why the final figures are not shown live throughout the day by adding a comment below.