One concept option traders need to understand is Open Interest. Although it is one of the most important data fields provided by the option exchanges (along with the Last price, Bid price, Ask price, and Volume), many traders ignore open interest all together. But while it may be less important than the option’s price, open interest does provide important information that should be considered when entering an option position.
Unlike stocks, where there are a fixed number of shares available to be traded, you can actually cause a new option contract to be created when you place an option trade. Open Interest tells you the total number of option contracts that are currently open. In other words, they have been traded, but not yet liquidated by either by an offsetting trade or by exercise or assignment.
Looking at an example, the at-the-money September 25 calls for Microsoft, it currently shows there are 17,200 contracts open. You may be wondering how many of those were bought and how many were sold by various option traders. The answer is you have no way to know for sure. That is why when you buy or sell an option, the transaction needs to be put in as either an opening or a closing transaction.
If you want to open a new position by buying 10 of the Microsoft March 25 calls because you expect the stock to go up in price, you would buy the calls to “open”. That purchase will add 10 to the open interest figure. When you close the position at a later date you would sell those same options to “close”. Open interest will then fall by 10.
Selling an option can also add to open interest. Let’s say you own 1,000 shares of Microsoft and want to do a covered call. You would sell 10 of the March 25 calls to “open”. Since it is an opening transaction, it would add 10 to the open interest. If you later repurchase those 10 options, you would enter buy transaction to “close”. Open interest would then decrease by 10.
It gets a little more complicated if the options you trade are not “created” by the transaction but instead have a trader on the other side doing the opposite transaction as you. For instance, if you are buying 10 of the Microsoft March 25 calls to “open” and you are matched with someone that is selling 10 of the Microsoft March 25 calls to “close”, the open interest number will not change.
So when you are looking at the total open interest of an option, there is no way to know whether the options were bought or sold. Since there is always a party on each side of every option contract, there is always that many outstanding long and short positions, although some of those contracts may in the book of one of the market makers on the exchange. Using our example of the Microsoft September 25 calls, all the long positions outstanding in everyone’s account would add up to 17,200 contracts, and all the short positions would add up to 17,200 contracts.
I think it is because open interest does not tell you if people are buying or selling that many option traders ignore open interest altogether. But that doesn’t mean the open interest figure provides no important information.
One use of open interest is to compare it to the volume of contracts traded that day. A day where the volume exceeds the existing open interest suggests that the trading in that option was exceptionally high that day. So open interest can help you determine whether there is unusually high or low volume for a particular option.
Most importantly, open interest tells you about the liquidity of that option. If there is no open interest for an option, it means there is no secondary market for that option, while options with large open interest means there are a large number of buyers and sellers. An active secondary market will increase the odds of getting option orders filled at good prices. So, everything else being equal, the bigger the open interest figure, the more attractive the option is.