Open interest in the options market is all about the total number of options contracts that haven’t been settled or closed yet.
If there’s a lot of open interest, it means lots of people are trading, making it easier to buy or sell at good prices. On the other hand, if open interest is low, there’s less trading happening, which might make it harder to trade without affecting prices too much.
For the folks setting up these trades, known as market makers, a high open interest at a certain price level means they have to work harder to keep things balanced.
This is because lots of open contracts at those prices could mean big risks for them, pushing them to buy or sell more of what’s being traded to keep their risk in check.
Open interest is more than just a number—it’s a lens through which traders can gauge market activity, liquidity, and sentiment.
What is Open Interest?
Open interest refers to the total number of outstanding options contracts that have been traded but not yet liquidated by an offsetting trade or by exercise or assignment.
In simpler terms, it’s the tally of all active options contracts for a particular security that are still “open” and have not been closed out or settled.
Why is Open Interest important?
Market Liquidity and Price Discovery
Open interest provides insights into the liquidity of options contracts.
High open interest suggests that there is a large number of buyers and sellers, which typically leads to tighter bid-ask spreads and better price discovery.
This environment enables traders to execute large orders more easily without significantly impacting the price.
Market Sentiment
Changes in open interest can indicate shifts in market sentiment.
An increase in open interest signifies that new money is coming into the market, suggesting that the current trend (upward or downward) might continue. Conversely, decreasing open interest implies that the market is liquidating, which could signal a reversal of the trend.
Volume vs. Open Interest
While volume represents the number of contracts traded in a day, open interest measures the total number of active contracts.
High volume in conjunction with rising open interest could indicate that the current trend is likely to continue. However, if volume increases but open interest decreases, it might suggest that the trend is about to change.
Open Interest and Market Makers
Market makers play a crucial role in the options market, providing liquidity and enabling trades by being willing to buy and sell options at any time.
A high level of open interest at specific strike prices requires market makers to manage their risk exposure carefully.
Delta Hedging
Market makers often hedge their delta exposure to remain neutral in the market.
Delta measures how much an option’s price is expected to move per $1 change in the underlying asset.
A significant number of open contracts at certain strike prices can expose market makers to directional risk, prompting them to buy or sell the underlying asset to maintain a balanced position.