Open interest (OI) tells us the degree to which traders in options and futures markets are considering trading in an asset, thus the term “interest.” In quantitative terms, it tells us how many contracts are still open in a particular market. As a gauge of the market’s strength, it reveals whether or not money is moving into or out of a specific contract.
An option or futures quote often displays open interest alongside the current price and volume. It’s important for traders to grasp how these factors relate. This will guide you in evaluating a futures or options transaction in the most accurate manner possible. In the eyes of traders, this is a significant quantity. It is a reliable signal that informs traders whether a market is becoming stronger or weakening.
Volume and OI have a close relationship in that they both show the amount of buying and selling that is backing the price movement. In order to better comprehend options and futures contracts, traders need to be aware of the relationship between these two metrics.
As more contracts come up in the market, the level of OI grows. It is a sign that investors are drawn to the traded asset. Therefore, this is often a signal of the impending rise in the price of an asset.
On the flipside, OI drops when buyers and sellers close out their holdings in current contracts. It means that investors have become less inclined to take fresh positions.
As a trader or investor, when you are in the loop about the levels of trading in the market, either in the form of Commitments of Traders or by actual completed transactions, you can assume an advantageous position. This kind of data may not tell you the actual happenings around the price actions of an asset, but they serve as good indicators of potential price direction.
Consider the following scenario: the open interest in the futures contract for commodity X is zero on day one. An investor purchases 10 contracts on the second day of trading. This means that the OI has risen from zero to 10.
Then on day 3 there was the closure of five contracts and the opening of 10 more. This results in a rise in open interest to 15.
The daily volume takes into account all transactions, regardless of how little or large they may be. One of the best indicators of market activity is trading volume, which directly reflects the value of a security’s liquidity.
Rising volume denotes that more traders and investors have taken an interest in an asset. A spike in trading volume gives a direction for investors to make their decisions.
Suppose that in the first session of trading, there was no trade in the contract for the contract in the example above, with a strike price of $10 and an expiration of four weeks. This would result in zero (0) trading volume.
Let’s assume that in the second session, an investor bought 20 futures contracts. This would result in a trading volume of 20.
Interpreting open interest (OI)
Analysts can assess the strength of a market trend based on OI. As OI rises, the trend is likely to continue; as it falls, the trend may be weakening. The assumption is that traders are backing the trend. In contrast, when it falls, traders lose confidence in the current trend direction.
At the end of each day, OI data is made available through publishing. The CFTC also publishes a weekly report called Commitment of Traders every Friday. Therefore, traders depend on this data to support their trading decisions. There are times when large fluctuations can indicate when specific people are entering or exiting the market, and these movements can also give us a sense of market direction.
Differences between the two
It is imperative that you realize that both metrics are meaningful in different ways, even as we compare them to one another. Both factors are measures of liquidity and activity.
OI tells us how many contracts are yet to close. Volume is a more precise estimate of how many securities were traded in a particular time period because of this difference.
The value of a stock may surge and plummet in a matter of seconds. It gives a sense of the general level of push and pull between demand and supply forces for a particular security. Volume tells us the value of trades completed in a certain period of time and for a specific asset.
The frequency with which new data is made accessible when comparing the two factors is another key distinction. The information on OI is updated with lesser frequency. The data is only reconciled at the conclusion of the trading session, in contrast to the near-real-time publication of volume data.
A guide to volume analysis
When the volume rises alongside the price and OI, it signals a strong market.
When prices rise but the volume and OI reduce, the market is considered weak.
The market is deemed weak if prices are falling while volume and OI are growing.
The market is in a strong position when prices fall and OI and volume reduction.
OI is almost always larger than volume. This is due to the fact that volume tells us the number of times a contract was traded on a particular day. The volume figure is reset to 0 at the start of each trading day.
In contrast, OI is the cumulative sum of all the contracts that are yet to be closed. Nothing returns to zero in this case. Thus, trading volume will tend to be much smaller.
When the volume exceeds the open interest
At times, volume surpasses OI. It is a sign of unusually strong trading activity, which is usually the result of new interest sparked by some sort of stimulus. It is usually the result of new developments around the fundamentals of an asset, which triggers increased activity.
Following such new developments, you must weigh between the raw market data and the potential impact of changes to fundamentals. Once you decide on which one carries more weight, it is easier to settle on a position with a specific market direction in mind.
For successful trading, it is essential to have a thorough understanding of the market. As you conduct market research, you should take advantage of both open interest and volume and take appropriate positions in line with the prevailing market conditions. Remember to also incorporate the effect of any shifts in fundamentals before initiating any positions.