Open Interest

Study Notes:

What is an option’s open interest?

The open interest in an option is a measure of the total number of open contracts that have been carried over from the close of the previous day. Open interest tracks the actual number of contracts open on each strike and right, this information can provide useful insights into liquidity, price movements, and demand of an option and play an important role as part of an investor’s overall research and understanding of trading options.

How is open interest calculated?

It is important for an investor to understand how option open interest is calculated and how it differs from overall trading volume. With every trade in an option contract open interest can either increase, decrease, or remain unchanged depending on if the buyer and seller are opening or closing.  Let’s walk through the following examples for a one lot option trade to get a better understanding of how open interest is calculated.

• If the buyer is opening and the seller is opening, then the open interest increases by one.
• If the buyer is opening and the seller is closing, then the open interest remains unchanged.
• If the buyer is closing and the seller is opening, then the open interest remains unchanged. And finally:
• If the buyer is closing and the seller is closing, then the open interest decreased by one.

Open interest is calculated at the end of each trading day, not in real time, so the data you see quoted is from the previous trading day.

Is there a maximum limit to option open interest?

Unlike equities listed on a public exchange there is no fixed number of contracts that can be bought or sold for an equity option strike. The number of open contracts can fluctuate each day and open interest can vary greatly from one day to the next depending on demand for a specific strike.

How is option open interest used by investors?

Option open interest can be used by investors as a liquidity indicator, to view market sentiment, see potential support and resistance levels, and for trading strategies. It is important to note that open interest is just one tool of many when it comes to analyzing options and that investors should make sure they have access to reliable data and are educated on what the data results possibly signify.

How can an investor use open interest as a liquidity indicator

Typically, higher open interest in a strike is one indicator that there is greater trading activity and liquidity in that strike.  Theoretically an infinite number of contracts could trade and be closed out each day, showing zero open interest but as a rule of thumb the greater the open interest the more likely that option has more liquidity than one with less open interest. Take for example the open interest in each strike shown for Apple’s June expiration. Now compare that to the open interest in the June expiration for Owens & Minor, Inc. The open interest is much higher in Apple and while an investor should use a combination of data points such as trading volume along with open interest, the initial deduction from comparing the open interest in Apple to Owens & Minor, Inc. is that the Apple June expiration is much more liquid.

How can an investor use open interest to view market sentiment?

Open interest can’t predict market movements; however, it can provide insight into market sentiment and which price levels there is interest in. For example, ABC stock is currently trading at $50 but there is large amount of open interest in the $60 call expiring three months away. While open interest doesn’t tell the investor who was buying and who was selling, the investor can extrapolate that there is interest in the 20% upside movement of ABC stock over the next three months and speculators are paying attention to the $60 price level in ABC stock.

How can an investor use open interest as an indicator for support and resistance?

Investors may also use open interest along with other data points as an indicator for support and resistance levels. If there is higher open interest at a particular strike, that may act as a gauge of support or resistance for that pricing level. In the previous example the investor may extrapolate that $60 may be a potential point of resistance in ABC stock.

What is a Gamma Squeeze?

Another potential effect if stock ABC approaches the $60 price level is that the seller of the calls may have to either roll their position up to a higher strike, out to further expirations, or cover some or all the calls by purchasing ABC stock. If the short call seller begins to buy ABC stock, this could further push ABC stock upward and is referred to as a gamma squeeze. While there is no limit to open interest for a particular option contract, an investor should consider the absolute number of shares represented in the open interest to the shares outstanding to make an informed decision on how the stock price could be affected if the short seller is forced to buy shares to cover.

How can investors use open interest for trading strategies?

Investors may look at open interest for potential trading strategies, concentrating on specific lines where there is a large open interest and potentially high daily liquidity and volume. Generally, the bid / ask spread is smaller for more liquid contracts and the investor may be able to get in and out of positions cheaply. Of course, tighter spreads do not guarantee a profitable trading strategy and the investor should research thoroughly before making any trading decisions.

Open Interest can provide valuable data that combined with other data points can help an investor in their option trading decisions.