Open Interest or OI is a parameter to measure the number of Outstanding contracts (Not Squared off) at a particular strike price. The near strike prices to the Spot has higher Open interest compares to OTM (Out of The Money) contracts. Higher OI has many benefits like High liquidity and low spreads and some disadvantages.
Open Interest or (OI) simply denotes the current open option positions or the current option contracts that are outstanding at a particular Strike Price. To simplify this further, when an Options seller sells 1 option contract, someone else buys it. This is known as an option transaction between a seller and a buyer. This can be also denoted as 1 Open Interest as long as the Seller doesn't square off his position.
The buyer of the Option can sell that contract to a different person creating liquidity. In this way, Open interest is also considered as a factor of liquidity.
OI or the Open Interest is an important parameter that tells you the liquidity or the buying and selling action on a particular Strike Price. A high Open interest ensures that the ‘spread’ between the buyers and sellers will be minimum. Spread denotes the price difference between the buyer and the seller. A high spread will ultimately erode one's profitability to some extent.
Let’s see this with an Example
Assume Nifty is trading at 15500 currently, which makes the 15000 CE (Call Option) an ATM (At The Money) option. The open interest of an ATM is high compared to an OTM (Out of The Money) Call. Due to this the spread in the 15000 CE will be as minimum as 0.05 points which translates to 3.75 rupees per Lot (0.05 X 75).
On the other hand, if you were to transact in a far OTM Call, for example, 16000 CE. There the OI will be less than half of that of an ATM strike price. Due to this, the spread can be as high as 0.10 to 0.20 points per lot. This means the person squaring off their positions will be losing almost 7.5 to 15 rupees per Lot.
A high OI also denotes the active participation by Buyers and sellers at that particular price point. This can cause high volatility in option prices. This means that prices of options contracts can rise and fall quickly due to excessive amount of buying and selling. New traders should stay away from such situations as the risk increases as the volatility increases.
To conclude it is understood that Open interest is the amount of the outstanding (Not Squared) option contracts for a particular Strike price. The open interest denotes the buying and selling activity by Options traders. A high OI means that more traders are actively trading in that contract. This increases the volatility which can be risky for new investors, as well as risk-averse traders. On the other hand higher, OI also means more liquidity which ensures quick execution of trades.
With a high open interest rate on options contracts, it's quite predictable that there are larger volumes in the trading options contracts. Moreover, the value of the options contract would be lower while trailing the closest index prices on that particular chart.