The term "open interest" refers to the number of open contracts for a certain future or option traded on the market. Because traders are constantly buying and selling contracts, this figure is subject to vary throughout the day. Because it may reveal whether a certain market is heading upward or down, open interest is a crucial indication for traders to keep an eye on.

Open interest is often shown with the current price (bid, ask, and last) and volume when examining a quotation for options or futures. The volume represents the total number of contracts that were exchanged. The volume of trades in a market is another important measure of the level of activity in that market. But it doesn't indicate whether a future or option is going toward buying or selling, which is a significant limitation.

The Mechanisms Behind Open Interest and Its Works

To determine open interest, sum up all of the contracts that are connected to opening transactions. After that, deduct all the contracts connected to finishing deals from the total. Take, for example, the scenario where three traders, are all active in ES futures market. Their transactions may influence the open interest in the following way:

• Trader A initiates a long position in the market by purchasing one contract.
• The open interest reaches a new high of 1.
• Trader B initiates a long position in the market by purchasing four contracts.
• The open interest reaches a total of 5.
• The trader known as Trader A gets out of the position by selling one contract.
• Open interest falls to a total of 4.
• Trader C initiates a short transaction in the market by selling four contracts.
• The open interest has reached 8 now.

When you consider that every trader is buying or selling from someone else who is buying or selling, open interest becomes a more sophisticated concept. At other times, one party will closing a deal while the other will initiate trades and raise open interest. Sometimes both parties will be opening trades and building open interest simultaneously (no effect on open interest). It's also possible that both sides are trying to close transactions.

What Open Interest Tells Individual Investors About the Market

Open interest is sometimes used to validate the direction in which prices are currently trending. However, by itself, it does not supply a significant amount of information on price change. The number of contracts that are now available in open positions is shown, but it does not indicate who is long or short.

A Quantitative Indicator of Either Strength or Weakness

As the number of contracts being traded increases, an increase in open interest provides an indication of the strength behind the present price movement. In other words, there has been an uptick in activity, and people are becoming excited about the move. A reduction in open interest indicates a potential deterioration in the price trend that has been developing recently. The rate at which traders are liquidating their holdings is now greater than the rate at which new traders create new positions.

Turnarounds in the Market and Range-Bound Conditions

The combination of rising open interest and prices suggests a potential continuation of the upward trajectory of prices. Nevertheless, a combination of falling open interest and rising prices indicates that rising prices may be poised to reverse.

A falling open interest implies that the pace of new positions is falling, which suggests that the market may see reduced active trading and is more likely to remain range-bound. This can be inferred from the fact that the rate of new positions is also falling.

Proceed with Caution

It's possible that there isn't an active market for an option or futures contract if there isn't much open interest in the contract. This information may also be obtained from volume. On the other hand, a large open interest does not always indicate that specific futures or options contracts will see a significant amount of activity on a given trading day. Because open interest is a reflection of open positions, such positions may continue to be open despite minimal activity; ultimately, those traders will ultimately desire to liquidate their holdings.