Open interest is a concept that, at some point, every options trader needs to understand. It reveals the total number of outstanding contracts in the market. Knowing what open interest means in options can help you gauge market activity and liquidity, making it a vital tool for managing trading risks. So, what is open interest in options? Let’s begin.
Key takeaways
- Open interest in options is the total number of outstanding contracts in a given market. High open interest can indicate increased market activity and liquidity.
- Open interest analysis is a very good tool for handling pin risk in options trading, as it helps determine potential future contract expiration dynamics.
What Is Open Interest in Options?
What is open interest? And what does open interest mean in options trading? In the context of derivative trading, open interest refers to the total number of outstanding contracts that have not been settled.
It serves as a key indicator of market activity and liquidity, providing insights into how many contracts are actively open at any given time. Understanding open interest in options is crucial for traders looking to gauge the level of engagement in a particular options market.
Open Interest and Trading Volume
Open interest and trading volume are often confused, but they measure different aspects of market activity. Trading volume represents the total number of contracts traded during a specific period, regardless of whether they are new or existing contracts being closed. In contrast, open interest only accounts for contracts that are currently open and have not been settled.
- Open Interest: This concept reflects the number of active contracts and indicates ongoing trader interest.
- Trading Volume: Instead, this shows the number of contracts traded within a certain time frame and can include both new and closed contracts.
Both metrics are vital for assessing the sentiment evolution in any market. High trading volume often corresponds to high liquidity, making it easier for traders to enter or exit positions. Meanwhile, open interest offers a snapshot of market sentiment, showing those strike prices where market participants are holding the most options contracts.
Which Value of Open Interest is Better?
The level of open interest can signal different market conditions and potential trading opportunities. High open interest usually suggests a strong market trend and heightened investor confidence, whether bullish or bearish. This can be advantageous for traders as it often coincides with increased liquidity. So, in this case, you could go ahead and pick one of those advanced trades like the put ratio spread (for a bullish market) and the call ratio spread (for a bearish phase).
There’s no “better value” for open interest. The trick, in this case, is to consider each strike price with its open interest. Imagine plotting an open interest curve where the X-axis is the strike price, and the Y-axis is open interest. In fact, here is what your open interest distribution may look like:
As you see, the open interest is not necessarily normally distributed (i.e., it doesn’t have a classic bell curve shape). You may find that some strike prices are more popular than others, and the general rule is to be more attentive to those areas with higher open interest.
Does it mean that the stock price will reach those levels? Not at all. But it does mean that there are more contracts trading at those strike prices, which could indicate strong market sentiment towards them (which can be a good thing to keep in mind, for instance, on the day your options expire).
Understanding Open Interest in Options Through Our Report
So far, we dealt with open interest in a very theoretical manner. But can you actually use OI to trade options? Yes you can. For instance, we offer a unique premium report that combines open interest data with a comprehensive analysis called the “Center of Mass” (CoM) report. This report highlights the aggregated positions of market participants for each stock, providing the distribution of open interest across various strikes leading up to the next monthly expiration.
The Center of Mass (CoM) report is designed to uncover where the majority of options trading activity is concentrated. It aggregates the total options volume and identifies the “center of mass” — the price level where most market participants are actively trading options. This helps traders predict potential price movements based on where the stock price is in relation to this center.
Additionally, since many market participants hedge their positions, the CoM report also reveals potential pressure points where stock prices may converge toward the center to minimize losses. The report is backed by research from the University of Miami Business School, showing short-term alpha in predicting stock moves over the following four days when comparing the CoM to the current stock price.
How to Use the Report
Our report is divided into two main sections. The first highlights the most notable divergences between the open interest “center” and the current stock price, offering three bullish and three bearish signals. The second section lists liquid stocks alphabetically, allowing users to easily find relevant data for stocks on their watchlist.
This is what our report looks like:
To effectively analyze the report, consider these aspects:
- Center of Mass: When comparing the current stock price to the ‘center of mass,’ it’s essential to identify the reason behind any divergence. If it stems from fundamental factors, expect the center of mass to shift toward the stock price. Conversely, if the divergence appears technical or unexplained, anticipate pressure for the stock to move toward the center of mass.
- Center of Mass Trend: Observing the direction of the center of mass can offer insights. If it seems extreme, a contrarian trade might be worth considering. Understanding this trend helps in building trading positions as it reflects the general sentiment of market participants.
- Options Volume + Volume Power: Available via our scanner, high volume often amplifies stock trends. Significant movements coupled with high volume suggest continuity.
- Pin Risk: This is particularly relevant during expiration. Since options expire on specific dates, there’s an incentive to keep stock prices near certain strikes. If the price is close to a strike with large open interest, this should be considered during expiration.
When using this report, remember it provides a snapshot in time and contains some noise. It’s crucial to review past reports and additional data to confirm signals before making trading decisions. Integrating this with your trading strategy ensures more informed decisions.
An Example of Open Interest on a Real Stock’s Options
To illustrate the practical use of our report, consider handling pin risk on an option’s expiration date. Suppose it’s Friday, and you hold calls on DOCU – as found on our options screener – expiring that day, while DOCU trades at $56.49. Your calls have a $58 strike price, and despite holding them for weeks, DOCU hasn’t shown the upward trend you hoped for.
With recent earnings reports, you’re uncertain how the market will react—will it focus on positive EPS or unclear guidance? Our report can assist here:
Start by looking at the orange bar chart: you’ll notice DOCU’s options have a significant open interest around the $60 area, with some traders even targeting $100. This suggests a bullish outlook, especially with the skewed OI distribution. Additionally, the report indicates DOCU’s center of mass is 4.54% above the current price, which is another nice thing to see if you want to justify the bullish case.
But did this actually work? Well, take a look at the price chart below:
At market open, DOCU hovered around $60, displaying volatility before declining, aligning with the open interest and center of mass analysis. You could have closed your position at market open, with a likely better profit (or lower loss) compared to the one you recorded on the day before the earnings (assuming that the typical post-earnings implied volatility crush did not reduce your calls premium by too much).
The Relationship Between Open Interest and Underlying Price
You now know what OI in options is, but let’s try to go further. Another very important thing to consider is the relationship between open interest and bull or bear signals. To get a clearer picture of market movements, compare open interest with the stock’s price, like we do in our table below:
When the price of the underlying stock is on the rise and open interest is high, it suggests that new money is flowing into the market. Traders are taking long positions, indicating a bullish market sentiment. Conversely, if the stock’s price is falling and open interest remains high, it’s a sign that the bearish trend might continue, with traders possibly opting for short positions.
Understanding what open interest means in options trading is crucial for interpreting these signals:
- Rising Underlying Price and High Open Interest: Indicates bullish sentiment and establishment of new long positions.
- Falling Underlying Price and High Open Interest: Signals ongoing bearish trend and potential short positions by traders.
In contrast, a decrease in open interest during a bull market may imply that investors are starting to doubt the strength of the trend. This could indicate that the market is approaching its peak, and a change in sentiment might be on the horizon. Similarly, low open interest in a bear market can point to uncertainty, suggesting that the market bottom might be near. During these periods, investors often hold back, weighing their options before committing to new strategies.
- Low Open Interest in Bull Market: Signals uncertainty, potential for market top approaching.
- Low Open Interest in Bear Market: Indicates possible nearing of a market bottom. In this case, investors are cautious and are awaiting a clearer direction.
Market tops and bottoms frequently occur alongside low or decreasing open interest. This is because opening new contracts can be risky during these potential reversal points. Understanding what OI is in options helps traders navigate these shifts, allowing them to make better-informed trading decisions.
