Open Interest in Options Trading: The Inside Story

Let’s say you’re at a music festival that has a mixed lineup, there are five different stages, and five different artists playing at the same time, all day. How are you supposed to choose which one to see if you’re open to them all? 

Do you choose the one where you see the most people? Or do you choose the one with far fewer people, perhaps thinking you’ve discovered a niche, an early trend. 

If you had a way to check how many people are at each stage you could have a better idea of how the music is trending around the festival. This is essentially what open interest is – a figure that tells you how many people are at a specific ‘stage’; more specifically, how many traders have a specific contract open.

So open interest is a figure in the stock market that tells you how many traders have active positions with a specific stock, or options contract. We’ll focus more on options here. 

The goal is to have this serve as a nice guide that helps explain this versatile tool, to help you spot trends in the market easier. Let’s dive in.

Understanding of Open Interest

Open interest represents the total number of options contracts that are open in the market. Options are contracts that represent other securities, like stocks, and give you the right but not the obligation to sell stock at a set price within a set time. 

Another way to think about open interest is to think about it as the total number of active contracts, as open interest does not include closed positions. This differs from volume, which includes sold potions in its figure. We’ll touch on that point later on. 

Open interest is calculated simply by adding the number of new contracts being opened and subtracting the number of contracts that have been closed, expired, or exercised. This number gives investors a good idea of how busy the market is, and also the level of demand for specific contracts.

Above is a screenshot from Robinhood of a PayPal call. In the middle and to the right, you’ll see “open interest”. At the time this was taken the open interest for that contract was 446, meaning 446 of that specific contract were open and active.

The Changes in Open Interest

Open interest fluctuates as new contracts are opened and existing contracts are closed. These fluctuations in open interest provide insight into the buying and selling activity in the market and can give us an understanding of market sentiment. This information can be quite helpful for investors to combine with other forms of technical analysis. 

Market sentiment can be thought of as, and is often referred to as, “The Fear and Greed Index”. Fear and greed are omnipotent in the stock market, and affect every price movement and shift in volume.

For example, if open interest is increasing, perhaps weighing heavier on the greed side of the scale, it may indicate that there is a high level of demand for the options contract and a strong up-trend in the market. On the other hand, if open interest is decreasing, it may indicate a weaker trend or less interest in the options contract.

Why is Open Interest Important to Investors?

Open interest is important to investors because it helps give them an idea of what the word on the street is. What others are ‘up to’. It helps keep your finger a little closer to the pulse of the market.

The market reacts to certain events or news, and open interest often reflects this, so it can provide valuable insight into how others are thinking. This plays into having a sense of the demand for a contract, as well as how liquid it is.

Difference Between Open Interest and Trading Volume

Open interest and trading volume are both critical indicators successful investors use. They do have the appearance to be similar, but there are some key differences.

Trading volume is the number of trades executed (coming in and going out) within a given time. Namely, if an investor buys 15 contracts and another investor sells 10 contracts and the given time is one hour, the trading volume is 25. 

Using the same example, the open interest would be 15, as 15 were bought but not closed, or settled yet. And open interest does not include settled, closed, expired, or exercised contracts, while volume does, as it’s more of an overall measure. 

Volume would be the total number of the day, buys and sells; and open interest is buys minus sells.

Open Interest as an Indicator for Trend Strength

Open interest can also be used as an indicator of the strength of a trend in the market. When open interest increases, it may indicate a strong trend, while a decrease in open interest may indicate a weaker trend. 

The indication it gives is solely based on the influence of market psychology. A lot of times when a trend starts to form, as with fashion or tech trends, others start to hop on the bandwagon. This is a predictable aspect of human nature that doesn’t just exist in pop culture. This is why we can reasonably assume that there may be strength in a trend if open interest is high, and vice versa.

But just with other trends we see, many often fall off after short term traction. And many times that’s surprising to us, but perhaps that’s because we were too emotionally involved and weren’t seeing the full picture. 

The point is, open interest as a direct indication of either the strength or weakness of a specific contract. Strength, in this context, is measured by demand and liquidity. 

How Do Investors Use Open Interest?

How investors use open interest can depend on several factors. Perhaps the most important is actually how they would make similar decisions outside of the stock market.

Following the music festival metaphor, let’s say you are at a festival and after you walk around for a little bit, you notice that one of the stages is packed with people. There must be a good reason for it, right? 

Now, are you the type to want to join the hype? Or maybe you hang more in the background to see how things unfold, see if people leave quickly or stay longer. Or maybe you abandon ship altogether because you’re a contrarian and want to choose the less-beaten path. None of these options is better than another, they just depend on who uses them. 

This same thought and decision-making process can be applied to the stock market if you’re looking at open interest figures. Investors use it in a myriad of ways. They can choose to use it as a more direct way to know when to jump into a position, when to sell a position, and also just to get an overall feel for demand.

High Open Interest

When the open interest for a specific options contract is high, it means that there is a lot of demand for that contract. This can be a good sign because it suggests a strong trend in the market, and it also means that there is a lot of liquidity in the options contract. 

However, high open interest can also be a sign of increased market risk, especially if there are a lot of speculative trades. Meaning, a lot of the ‘bandwagon trades’ that are a result of higher open interest may more so be ‘let’s-see-what-happens’ trades. This is dangerous, and creates a bubble that will pop, we just don’t know when. 

So high open interest statistically points to a contract that is indeed trending. You just have to be careful about all the other surrounding variables that increase risk. 

Why is Liquidity Important?

Liquidity is important for investors because it is essentially a measure of how quickly you can open and close a position. This is because if more people are participating in an exchange, the higher the likelihood you’ll find a buyer or seller for a contract. How quickly you can buy and sell is important because the hiatus in between the position being bought or sold is no man’s land, the underlying price can move in an unfavorable direction during that time.

Assets with high liquidity are considered less risky and more attractive to investors. When assets are highly liquid, it’s easier to enter and exit trades, and it’s also easier to find buyers and sellers for the asset. Purchasing options contracts with low liquidity is a frequent mistake of beginner traders, as selling the contract can be very difficult. All of these factors make liquidity an important consideration for investors.

This relates directly to open interest because the higher the open interest, the more contracts are open, thus more participation, i.e., more liquidity. This means that liquidity and open interest are directly correlated.

An Example of Open Interest

Let’s say that you’re interested in investing in Tesla (TSLA) and you want to spice things up with some options contracts. As an experienced investor, you know to at least glance at the fundamentals, but need to look at the open interest also. Let’s say for this example the open interest is 500, meaning there are 500 (specific) open option contracts open for TSLA.

You feel that this is relatively high so you throw it in your watchlist to see what happens. Some days pass, and you notice the open interest has gone sky-high. What do you do?

Well, based on the theories of open interest, we can reasonably say that TSLA is trending, and there is a strong signal to buy; so you decide to buy a few short-term calls to hopefully capture some profit. That’s all there is to it!

The key here is how you use it. Others, given the same circumstance as described in the above example, might decide to hang tight, see what happens, and if the price does rise by quite a bit, they slide in at the top with a few bearish plays, perhaps some simple long puts, and make money on the way back down. Play around with it and see what works for you.

Pros and Cons of Open Interest in Options Trading

Open interest can be a valuable tool for options trading because it provides insight into market activity and demand for a specific options contract. It should not however be used exclusively to make decisions, as you could easily juxtapose other forms of analysis with it, strengthening, or weakening what its indication may be. So a disadvantage of open interest is that it is weak on its own.

We’ve talked a lot about how open interest can indicate market sentiment and trends, but we didn’t touch on the fact that open interest never tells you when those events will happen. It just indicates that they may. This isn’t a great formula for instilling confidence, so again, it’s a good idea to cross-reference with other information and data you can collect. 

On the more bright side, however, a major benefit to open interest is that it is an indicator that can build strength over time. If you for example record the open interest of a contract, analyze how the price moves and how interest changes, and continue to build that sort of information log, it can become a powerful tool!

Another great benefit is that it is an easily digestible piece of data. It doesn’t require you to do very much, whereas with more advanced chart patterns you are drawing lines, questioning if you’re actually seeing the trend you think you’re seeing, etcetera. But open interest is just a raw, solid figure.

Conclusion

Open interest is commonly used by investors in similar ways as volume to help get a sense of how the market is trending, and what the demand is for specific contracts. It is a measure of how many active, open options contracts there are. Namely, how many contracts of a specific asset have not been settled. 

This not only helps investors know where the market may be trending, but also how liquid it is. Higher liquidity is more advantageous to investors because the higher the liquidity, the faster they can enter and exit positions at the prices that they want. 

Open interest is indeed a powerful tool, but it shouldn’t be your lodestar. Combining it with other indicators is key to giving it strength. For example, if there is an increase in open interest for a contract, it’d be smart to cross reference that with something like a break out of a support or resistance line, because if both point to the same thing, you vastly increase your chances to profit. Adding something like options alerts can be another layer that can greatly further your chances of success.

Play around with it! Look at open interest for contracts you might be interested in, write them down, check back in a few days later, see what changed. If there was a big move, read some news about the underlying company, see if there is any correlation. Write that down. This is how you start to build a bigger picture of the market and nourish your intuition. 

Open Interest in Options Trading: FAQs

Is Higher Open Interest Better?

Higher open interest can indicate a strong market demand for a specific options contract, suggesting a strong trend in the option. However, high open interest can also indicate a large number of speculative trades, which can make the situation riskier. Investors need to consider both the potential benefits and risks when evaluating the impact of open interest.

Is Open Interest Bearish or Bullish?

Open interest is an inherently neutral measurement of market activity and demand for a specific options contract. It doesn’t indicate a bullish or bearish market sentiment. 

Low open interest, however, is generally a bearish indicator; and high open interest is generally a bullish indicator.

How Can Traders Judge Open Interest?

One of the key factors traders can use to gauge open interest is the current percentile of the open interest. If this is high, relative to the previous open interest seen, this generally suggests traders see a period of incoming volatility, which options contracts can potentially benefit from. As of late-January 2024 for example, $NIO’s open interest of 2.2 million contracts ranks in the 84 percentile, meaning within the last year, $NIO open interest had only been higher 16% of the time. This higher percentile suggests a large number of options traders have found something in $NIO which they believe will lead to volatility.

What is a Good Open Interest for Options?

There is no specific number that defines a good open interest for options. What is considered a “good” level of open interest can vary depending on the specific options contract and market conditions.

Outside of that though, there are some other ways of determining what may be considered a good open interest. One way is to build a history. What has open interest been in the past when there have been large price movements? Is open interest around the same as it was in those times? Those are important questions that can help you figure out what a good open interest might be. 

If you have seen consistent price growth after open interest reaches about 350, for example, then this may be considered a good open interest to you. 

Another way to judge if open interest is good is to create a scale. Compare it to another open interest figure for the same contract. You can’t work with open interest if it’s in a vacuum. But if open interest was 65 a week ago, and 85 today, you may consider that a good (or at least better) open interest.

So it all depends on what you make of it. But there is not an objective, good open interest number.

Is Open Interest a Good Indicator?

Open interest can provide valuable information about market activity and demand for a specific options contract. However, it should not be the sole factor in making investment decisions. Other indicators, such as chart patterns and moving averages, should also be taken into consideration.

As we touched on above, a lot of it has to do with what you make of it. If you make investment decisions only based on open interest, you’ll probably find that it’s not the greatest indicator, but if you combine it with other indicators, maybe you’ll find it’s a great one!

What Happens When Open Interest Increases?

When open interest increases, this generally means that that specific contract is trending, meaning liquidity is increasing, along with demand. This points to a potential bullish move, creating an opportunity for investors to profit.