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Trader's Corner

Concepts of Open Interest in Options

HAVING TROUBLE PRINTING?
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This week's mail brought this query from one of our Option Investor subscribers. This mail from my inbox seemed like a good topic to refresh the old knowledge bank with our readers. It may be also that my brain is on low partial shut-down holiday mode, but the topic is one that provides some useful information or a reminder to all us option traders:

"Hello Leigh, love reading your column. My question is on open interest. I've done some reading on it buy I can't find exactly what I'm looking for. Here are my questions:

1. How does volume impact open interest?
2. Can I tell if the Open Int is short or long the position?
3. Can I tell if the Vol is short or long the position?
4. What do the different levels of open interest tell you about what traders are expecting the underlying stock/index to do (for example 'max pain' or what could I discern from a large open interest 20 points above or below where the SPX is currently trading)?"

RESPONSE:
Well, of course, not for you so much but to cover all the bases, the DEFINITION of Open Interest (OI) is the number of outstanding option contracts in a particular option class or series; you also see OI quoted for the total of outstanding contracts for ALL index or all equities options, or both together. Open Interest is the total number of options that are not closed or delivered on a particular day, hence the term 'open'. [OI also pertains to the total contracts open or outstanding for a particular (month's) futures contract or for ALL contracts, such as for the S&P stock index futures.]

An option example:
Day 1: 5 new calls bought, 5 newly sold; Volume = 5; Open positions or Open 'Interest' = 5
Day 2: 10 new calls bought, 10 are new sells (shorts); Volume = 15; OI = 15 (rising volume, rising OI)
Day 3: 3 new calls are bought; 3 are newly sold; Volume = 3, OI = 18 (falling volume, rising OI)
Day 4: 10 new calls bought; seller is exiting 10 calls; Volume = 10; OI = 8 (rising volume, falling OI)

Question 1: How does volume impact open interest?

Volume doesn't 'impact' Open Interest directly. Trading volume is of course always relative to the average or recent trading volume of the option in question. We want to know if today's volume is large or small relative to what has come before. Mostly, in technical analysis terms, volume will be looked at in terms of the price TREND. In a technically 'strong' trend, volume should expand in the DIRECTION of the price trend. But Open Interest also has a relationship to volume. Volume and Open Interest 'should' or will tend to move in SAME direction, as suggested below in the rules relating to the price trend.

In an uptrend, we expect volume to increase with prices. In a downtrend we anticipate that volume will increase on declining days, at least on balance. A large percentage change in price that's accompanied by larger than normal trading volume is a good indication of market strength in the direction of the change. Conversely, a large percentage increase/decrease in price accompanied by a relatively (relative to the prior average daily volume) low small trading volume is less likely to indicate a new price direction. In fact, it might indicate a possible reversal in the trend.

There are some rules of thumb that have been seen to have validity over the years for BOTH volume and Open Interest (OI):

PRICE...VOLUME...OI...TREND
Rising...Up......Up...Strong
Rising...Dn......Dn...Weak

Prices in an uptrend, with daily Volume and OI rising is interpreted as new money coming into the market (reflecting new buyers) and is considered bullish. If however, prices are rising on falling volume with Open Interest also declining, short sellers are assumed to be covering their positions and causing the rally. Money is therefore leaving the instrument in question and is considered bearish.

PRICE...VOLUME...OI...TREND
Falling..Up......Up...Weak
Falling..Dn......Dn...Reversal potential**

If prices are in a downtrend on increasing volume and open interest is on the rise, technical type traders figure that new money is coming into the market, showing aggressive new shorting. This scenario then suggests a continuation of a downtrend and a bearish condition.

**Lastly, if the volume trend and total open interest is declining along with prices, the decline is likely to being caused by disgruntled long position holders liquidating their positions. Technicians view this scenario as one of a declining trend but also being a 'strong' candidate for an upside reversal at some point, as the downtrend will end once all the sellers have sold their positions.

SUMMARY: OPEN INTEREST
Bullish: Increasing OI in a rising trend
Bearish: Declining OI in a rising market
Bearish: Increasing OI in a falling trend
Bullish: Declining OI in a falling market (potential)

When open interest is high at a market top, relative to what the average OI has been over the course of the trend and then prices fall dramatically, this situation is suggestive of a TOP, suggesting that all of the long position holders that bought near the top of the market are now in a loss position; and their panic will keep prices under significant pressure.

(Subscriber) Question #2:
Can I tell if the Open Interest is short or long the position?
NO.
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, which is probably why many option traders ignore open interest altogether. However, OI does provide some key or ancillary information as already discussed.

The question was not asked here, but one way to use OI is to look at it relative to the Volume of options traded. When the volume exceeds the existing OI on a given day, this suggests that trading in that option was exceptionally high that day. OI can help you determine whether there is unusually high or low volume for any particular option.

Open Interest (OI) also of course gives you key information regarding the liquidity of an option. If there is no or very little OI for an option, there is or a very limited secondary 'market' for that option. When options have a large OI, it means they have a large number of buyers and sellers and an active secondary market will increase the odds of getting option orders filled at good prices. So, all other things being equal, the bigger the OI, the easier it will be to trade that option at a reasonable spread between the Bid and Ask.

(Subscriber) Question #3:
Can I tell if the Volume is short or long the position?
NO

(Subscriber) Question #4:
What do the different levels of open interest tell you about what traders are expecting the underlying stock/index to do (for example 'max pain' or what could I discern from a large open interest 20 points above or below where the SPX is currently trading)?"

There's not a lot that a large Open Interest can tell you when it's well above or below the current level of the underlying index in the case of the S&P 500 (SPX), except that traders are anticipating a large move before expiration.

Martin Pring, a well-known technical analyst, wrote a good SUMMARY of what Open Interest can possibly 'tell' us about the future price direction as follows (some points are all/partial repeats):
1. If prices are rising and Open Interest (OI) is increasing at a rate faster than its prior 1-2-5 year trend, this is a bullish sign. More participants are entering the market, involving additional buying, and any purchases are generally aggressive in nature. (But who has these averages? Not I! Not usually anyway)
2. If the OI numbers flatten following a rising trend in both price and OI, take this as a warning sign of an impending top.
3. High OI at market tops is a bearish signal if the price drop is sudden, since this will force many 'weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral.
4. An unusually high or record OI in a bull market is a danger signal. When a rising trend of OI begins to reverse, expect a bear trend to get underway.
5. A breakout from a 'trading range' will be much stronger if OI rises during the consolidation. This is because many traders will be caught on the wrong side of the market when the breakout finally takes place. When the price moves out of the trading range, these traders are forced to abandon their positions. It is possible to take this rule one step further and say the greater the rise in open interest during the consolidation, the greater the potential for the subsequent move.
6. Rising prices and a decline in OI at a rate greater than the past 1-2-5 year average is bearish. This market condition develops because short covering and not fundamental demand is fueling the rising price trend. In these circumstances money is flowing out of the market. Consequently, when the short covering has run its course, prices will decline.
7. If prices are declining and the OI rises more than you are used to seeing or what has been the average, this indicates that new short positions are being opened. As long as this process continues it is a bearish factor, but once the shorts begin to cover it turns bullish.
8. A decline in both price and OI indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.

GOOD TRADING SUCCESS!

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