Open Interest is nothing but the total number of outstanding option contracts present at a particular point in time. Open Interest is beneficial and harmful in some cases. Open Interest is analyzed by analysts, traders, and investors to determine various aspects of the markets. These include trends, Support and resistance zones, etc. Find out the uses of OI and if a high Open interest is Good or Bad!
Before we find out if high open interest is good or bad, Let's understand what is Open Interest?
Open interest (OI) is the total number of Option contracts that are outstanding in a particular strike price. Open Interest can also be anticipated as, how many options traders have not squared off their existing positions.
Open Interest is used for many things. Technical analysts use OI to determine the strength of the trend. An uptrend or downtrend with increasing open interest signifies a strong trend that can continue. On the other hand, a trend with falling Open interest can be a sign of a trend reversal.
Investors also study the OI to figure the Support and Resistance zones of individual stocks and indices. The Support and resistance zones ordinarily have a High OI on both the Call and Put option sides.
Now that you have understood what is Open Interest, it's time to figure out is High Open Interest Good or Bad. For this let's see the effects of high open interest.
1. High Liquidity
High Open Interest means that a large number of options traders are actively trading in that particular underlying asset. This makes getting in and out of trades easier and faster. One can place bulk orders without moving the price in either direction.
2. Decrease in Spreads
when the Open Interest is high in a particular asset, there are many buyers and sellers present in the market to transact the option contracts. Due to this high liquidity, even larger orders get executed at the wanted price. If the liquidity had been low, then the buyer/seller of the option would have to bear an unnecessary charge known as the spread. A spread is a difference between the buying and selling bid.
A high OI creates high volatility in an asset. When a substantial number of active traders are actively participating in the contract, the volatility increases. This can increase the price swings to a large extent. This might be beneficial to some but on the other hand, this also suggests more losses for someone. Higher volatility can cause more losses to retail traders as price swings are wild. Due to this a high VIX or volatility period is not a good time for new traders to enter the markets.
After looking at the features of high Open Interest, it can be said that a High Open Interest does more good than harm. A higher OI means one can actively get in and out of trades without any problem due to high liquidity. If the OI is low, the buying and selling spread becomes larger that can eat into the profits of traders.
Although higher OI leads to increased volatility, one should access the risks before taking a trade. Stop losses and money management should be followed strictly when it comes to derivatives traders. Without these one can face huge losses as trading is a “Zero Sum Game.”
Open interest might provide a strong indication of the direction of the trend all thanks to the volume of the open options contracts. However, the volatility and the abrupt downfall might prevail.