Open Interest is the number of outstanding contracts in derivatives like futures and options that have not been settled yet. Overall, the it provides an insight in understanding the options trading activity, or if the money flow is increasing or decreasing.
In order to understand open interest, you must first know how options and futures derivatives work. Firstly, if an option contract exists it means that for every buyer there is a seller on the other side otherwise the contract would not exist. Both sides, buyer and seller, create one contract that equals 100 shares of the underlying asset. Contracts are considered open until the counterparty closes them and therefore resulting in this term.
In order for the open interest to increase, the buyer and seller must initiate a new position of one contract that will then increase it by one contract. The same goes for the opposite scenario when they both decide to exit one contract, therefore decreasing it by one contract. Buyers and sellers can pass their positions to new participants that will keep the it unchanged.
John buys 1 option and Bill sells 1 option
Mark buys 10 options and Jason sells 10 options
John sells his 1 option and Jason buys 1 option
Frank buys 10 contracts from Mark who sells 10 contracts
Explanation: On March 1, only one contract is created therefore open interest is one. The next day 10 more contracts are created so it increases to 11. Then contracts decrease by one because John and Jason sold 1 contract to close their positions. Then investor Frank bought 10 existing contracts from Mark which is why it remains 10.
Trading volume and open interest require different measures. Above we explained that when a buyer transfers its contracts to a new seller that enters the market, the transfer of contracts does not create a change in the open interest figure for that particular option. However, assuming that the number of contracts transferred was 10 it will increase the trading volume figure for the day by 10.
High open interest means that there are many contracts still unsettled (open) therefore participants will pay close attention to that underlying asset.
Low means that nearly all the positions have been closed.
No interest means there are no opening positions.
The higher it is, the higher the money flow is in that specific market. Decreasing it indicates money flowing out of the market.
Keep an eye on the new terminologies Interest rates, options and futures will be published here soon!