The significance of open interest
This lesson will cover the following
- What open interest is
- What changes in open interest reflect
- Decision-making based on open interest
We have not discussed open interest much in our guides so far, which is why we will dedicate this article to it. In the options and futures markets, open interest represents the total number of contracts at the end of the current day that have neither been closed nor delivered, and therefore the number of existing contracts. In the stock market, it reflects the number of buy orders submitted before the market opens.
It is a common misconception that volume and open interest are the same. Open interest changes when new traders enter the market or existing ones leave it, because their trade either creates a new contract or closes an old one. For example, if the open interest in July silver futures traded on the COMEX division of the NYMEX is 5,000, then 5,000 contracts are held by bulls and 5,000 by bears. If that number rises to 5,500, it means that 500 new contracts have been bought and sold short.
Conversely, if open interest falls to 4,500, it means that bulls have closed 500 long positions and thus sold, while bears have covered their shorts and thus bought. If a new bull enters the market and buys a contract from an old bull, open interest remains the same because the number of contracts has not changed; they have merely changed owner. The same logic applies to bears.
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Overpowering the counterpart
Open interest illustrates the intensity of the battle between bulls and bears. The higher the open interest, the stronger the disagreement between the two counterparts, as both bulls and bears are willing to maintain their long and, respectively, short positions. When either side reaches the conclusion that the market will not move in its desired direction, it will logically close out positions and open interest will decline.
As bulls and bears battle each other, one side is bound to lose, but as long as there is a steady stream of potential losers entering the market, the trend will continue. Rising open interest means that the number of losers is increasing. In a bullish trend, for example, rising open interest implies that bulls are buying, while shorts are selling because they are convinced the market has reached a high level and will soon reverse. When the losses become unbearable, they will cover their positions, and therefore buy, which will drive the market even higher. If no new shorts enter the market, however, the trend is likely to exhaust itself soon enough. Rising open interest during a trend is therefore favourable for its development and implies it will continue. The same logic applies to bearish trends.
If a bull wants to buy but there is no bear willing to sell, the only possible way for him to procure a contract is to buy from an old bull who previously bought lower and is now selling higher. In this situation, open interest remains the same because no new contract has been created; it is merely changing hands. If open interest remains flat during a trend, it suggests that the number of losers has stopped increasing. The same logic applies to downtrends.
The last possible scenario is for open interest to decline. Declining open interest means that losers have given up hope and are exiting the market. As the conflict between bulls and bears eases, the trend is likely to reverse soon. While the losing participants are exiting and are not being replaced by new losers, activity declines, prompting the winning party to take profits and shortening the trend’s life. For example, in a bullish trend, as shorts exit the market (cover their positions and buy) and are not replaced by new shorts, winning bulls close their positions and sell; thus both exit the market and activity stalls.
How to incorporate open interest in trading
Based on what we have already said, we can summarise that positive and negative changes in open interest, as well as a lack of change, provide information about current market conditions and allow predictions about future developments.
When open interest rises during a trend, it suggests that the inflow of losers is increasing and the trend will be sustained; therefore, a with-trend position is in order.
When open interest flat-lines during a market rally, it implies that the trend is in its exhaustion phase and the best long trades have already been executed. This suggests avoiding new entries and tightening stops on existing positions in preparation for the impending end of the trend. The same logic applies to bearish trends.
When open interest declines during a rally, it shows that the two parties are reaching an agreement and are exiting the market. In a bullish trend, shorts cover their losses while bulls lock in profits, generating a bearish signal. The opposite applies in a bearish trend. As a trend is accepted by the majority, its end draws near.
When open interest rises sharply while the market is in a trading range, this should be viewed as a bearish sign because it implies that commercial hedgers are more inclined to short than speculators.
When open interest declines during a trading range, it generates a bullish signal, as it implies that commercial hedgers are covering their shorts in expectation of rising prices in the future.
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In general, volume and open interest are regarded as ‘secondary’ technical indicators used to confirm other signals on the charts. Thus, experienced traders don’t base their decision-making solely on them; instead, they use them alongside other indicators to confirm signals and to predict the extent of a market move. For example, a breakout accompanied by large volume suggests the move should be extensive, while a trend marking a new high on the basis of low volume should raise concern.
Moreover, the higher the open interest, the more liquid the market is, which improves the execution of orders and reduces slippage. Thus, short-term traders who get in and out of trades more frequently, especially day traders, should choose markets with the highest open interest. The same applies to trading futures – you should choose the delivery months with the highest open interest.