Open Interest is a parameter used by technical analysts and options traders to judge the mood of the market. Open Interest is the total number of outstanding option contracts in a particular strike price of an underlying asset. The OI is an important factor as it defines liquidity and the total number of contracts that are traded at a particular point in time.
Open interest is a number that is used to denote the outstanding or open Option contracts at a particular strike price. In layman's terms, open interest is the total number of options contracts that are not yet squared off at a specific strike price of an underlying asset. Open Interest is not just determined by selling or buying an option. Open interest is formed when buying as well as selling happens simultaneously.
Open Interest or OI is used by traders and investors to determine the mood of the markets or a particular Asset. Open Interest is viewed in derivatives products such as Options and Future contracts. In Options, the total number of option contracts sold and bought by traders is determined by Open Interest.
For example, an Option Seller sells 1 Lot of Call option at 15000 of the Nifty. At the same moment, an option buyer bought the 15,000 CE (Call option) from the Seller of the option contract. This created an open interest at the 15000 CE of Nifty.
In the same way, if 100 Option sellers sell a total of 500 lots of Call options of Nifty at 15000 and the equivalent number of options are purchased by Option buyers. The total open interest of 15000 CE will be 37500 (500 x 75).
Let's consider a scenario where there are 5 (A, B, C, D, E) market participants (Option Buyers and Sellers).
If A & B sell 4 options in total and C buyers the 4 option contracts then the total OI (Open Interest) will be 4.
Now when C sells the Options to D & E, then the OI will remain the same as 4 as the total number of Option contracts remain the same as 4.
In the situation where A buys back 1 option then the total outstanding contracts will become 3, and so will the OI.
Similarly, the concept of Open Interest works in the stock markets, the only difference is that there are millions of Sellers and million of buyers trading options at one single strike price.
The Open Interest is a parameter used by traders to judge the market sentiment. A higher OI means that more and more market participants are interested to enter in a particular price point. The OI also denotes a zone of support or resistance for any Index or Stock.
For example, if Reliance Industries has a large amount of Open Interest at the 1900 Put Option. The current price of Reliance being 2000, this denotes that people are betting that Reliance will not fall below 1900 in the short term. The 1900 price zone will act as a support in this case.
At the same time if the 2100 Call Option seems to have the highest open interest on the Call side then that will act as a Resistance for the stock.
Although this is not a thumb rule to follow still considered a method to judge the sentiments of the underlying by looking at the Open Interest.
Open Interest also denotes the liquidity in a strike price. A higher OI is good for traders as the entry and exit orders are met instantly. The spread between the buying price and selling price also reduces will high OI. One can execute large quantities without worrying much about the liquidity crunch or slippage. Slippage is the extra price difference that one pays while executing large sums of orders. This can be also denoted as a spread. A lack of liquidity especially at the OTM (Out of The Money) options can cause abnormal price spreads due to the lack of a number of buyers & sellers.
Volatility is another by-product of high Open Interest. High open interest in a strike price simply means that more traders are actively trading that particular strike price. This in return makes the price fluctuations more violent compared to the underlying asset. A small price movement in the underlying can send prices of options flying in either direction when the OI is extremely high or extremely low. In return, this can cause huge losses if one does not manages their positions properly. Due to this traders are recommended to stay away from markets when the VIX or the volatility index is high.
To conclude, Open Interest is an important data point to consider as a trader as well as an Investor. The OI helps traders to trade in and out of derivatives easily. On the other hand, investors keep an eye on the OI to judge the future price movement of the stock so that they could adjust their positions accordingly. A higher OI is preferable in options as it becomes easier to get in and out of a trade without paying additional in slippage or spreads.
High OI also leads to increased volatility in that particular derivatives contract. Due to this price fluctuations can be wild in Options with very high OI. Traders often get trapped in such situations where a major price movement in the underlying asset can send the option prices flying in either direction. This can cause huge implications to the retail trader.
Do mention if you have any similar instances while trading options in a volatile market.