Open Interest
Open interest is the number of active contracts. It's one of the data fields on most option quote displays, along with bid price, ask price, volume, and implied volatility. Yet, many options traders ignore active contracts, which can lead to unforeseen consequences.
Open interest indicates the total number of option contracts that are currently out there. These are contracts that have been traded but not yet liquidated by an offsetting trade or an exercise or assignment.
When you buy or sell an option, the transaction is entered as either an opening or a closing transaction. If you buy 5 calls from XYZ, you are buying the calls to open. (Each call represents 100 shares, so that's 500 shares in total.) That purchase will add 5 to the open interest figure. If you wanted to get out of the position, you would sell those same options to close. Open interest would then fall by 5.
Selling an option can also add to the open interest. If you owned 500 shares of XYZ and wanted to do a covered call by selling 5 calls, you would be entering a sale to open. Since it is an opening transaction, it would add 5 to the open interest. If you later wanted to repurchase the options, you would enter a transaction to buy to close. Open interest would then decrease by 5.
When you are looking at the total open interest of an option, there is no way of knowing whether the options were bought or sold. That's probably why many options traders ignore open interest altogether. However, you shouldn't assume that there's no important information there.
One way to use open interest is to look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, it suggests that trading in that option was exceptionally high that day.
Open interest also gives you key information regarding the liquidity of an option. If there is no open interest in an option, there is no secondary market for that option. When options have a significant open interest, it means there are a large number of buyers and sellers out there. An active secondary market increases the odds of getting option orders filled at good prices.
All other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask.
Trading does not occur in a vacuum. Indicators that show you what other market participants are doing can inform your trading system. Daily trading volume and open interest can be used to identify trading opportunities you might otherwise overlook. These indicators are also useful for making sure the options you trade are liquid, allowing you to easily enter and exit a trade at the best possible price.
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