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.
What does open interest mean in options?
Options open interest is the number of open contracts that remain for an expiration. This includes contracts that have not been exercised, offset, or expired.
Beginning options traders often confuse open interest with volume. As a stock trader, you only really have a single measure of liquidity and activity which is volume.
However, as options traders you have to consider both volume AND open interest as they are completely different data points.
Open interest only increases with new contracts
When traders create brand new contracts 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 a new contract in the market.
Open interest can decrease if both the buyer and the seller close their existing position. In this case, the single contract they traded would terminate and reduce the market’s open interest.
Let’s go through an example
So, in this example, we have five traders who are labeled A, B, C, D, and E.
Trader A decides to buy a contract at the same time that Trader B decides to sell a contract. The result is the creation of a single brand new contract.
Trader C later also decides to buy five contracts at the same time that Trader D decides to sell five contracts. Just like the transaction between A and B, the new agreement creates five brand new contracts. Now the total is six open contracts.
After two days of trading A decides to sell his contract. At the time B is not willing to sell his contract, but D is prepared to sell one of his five. This results in a valid transaction and the closing of one contract. Open interest drops to five.
Finally, Trader E comes into the market and decides to buy five contracts from C. Trader C already owns the contracts, so his sale will help fund the purchase for E. Since there is no newly created contract, 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.
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 right. Higher open interest simply means that there is higher activity and interest in that particular strike price. Remember, one contract means you have a buyer AND a seller, and they both can’t be right.
I understand open interest – How does it fit with volume?
If you’ve followed me this far, you probably have a good idea about what open interest is and isn’t. Let’s make sure you still understand volume as it relates to options trading.
For options, volume is simply the raw number of contracts that have changed hands on a particular day. This is irrelevant of whether a new contract was created or not.
This might explain why you might see a large volume of 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.
What does it mean if there is no open interest?
A lot of people have asked what it means if there is no open interest in any contracts. This is because open interest is calculated after the close of every trading day and is recalculated the next day. Whenever you see open interest on the platform, it will be for that trading day.
In the case where contracts started trading today, there will be no open interest because there were no contracts before today. If you wait a day or two, you’ll start to see the open interest increase as traders buy and sell contracts.