Total number of derivative contracts open
In short:
Open interest (OI) represents the total number of derivatives contracts, such as futures and options, that are currently held by market participants at the end of a trading day. More specifically, for every buyer of a derivatives contract, there must be a seller to create a contract, OI represents the number of these contracts that have not yet been settled.
Often, OI is used as a gauge of money flowing into or out of derivatives markets and therefore an indication of trend strength.
In-depth:
How Open Interest Works
To understand open interest (OI) it’s helpful if we discuss how derivative contracts are formed as they are different from other securities.
For futures and options contracts, collectively called derivatives, a contract is only formed if and when a buyer and a seller meet. For example, consider options which give the buyer the right but not the obligation to buy/sell the underlying asset from/to the seller of the options contract. An options contract is only formed when the buyer and seller agree to the terms of the contract including price.
Since most options are traded on exchanges, the terms of the options contracts such as how much of the underlying asset the contract will represent, duration of the contract and so on have already been outlined. Therefore, the only thing left to agree on is the price which will reflect the risk/reward tradeoff each side is willing to accept.
Once a buyer and seller agree to the price, a contract is created and OI increases. This process is the same for both options and futures.
The important thing to note is that OI increases regardless of selling or buying, that is, buying doesn’t necessarily mean increased OI, likewise, selling doesn’t mean decreased OI.
Open Interest Vs Trading Volume
It’s not uncommon for people to confuse open interest with trading volume even though they are not the same thing.
Trading volume represents the number of times contracts change hands in a trading day, whereas open interest represents how many contracts are outstanding at the end of a trading day.
For example, say we own 50 soybean futures contracts and decide we no longer want to own these contracts. To exit our position, we sell our 50 soybean futures contracts to another trader who wants to own the contracts. Since our position was taken up by another trader the open interest does not change and remains at 50 (assuming we were the only ones holding contracts). However, since contracts change hands trading volume increases by 50.
Using Open Interest
Open interest is used by traders as a tool to add context to market trends. Since increasing open interest indicates money flowing into a market, increasing open interest can indicate if an existing market trend is gaining momentum or likely to continue. On the other hand, open interest can also help indicate the relative weakness of a trend.
For example, say we are looking at an upward trending market in crude oil futures. If we see increasing open interest behind the uptrend, this may be an indication that the trend is gaining momentum and may run further. However, if we have the same uptrend but see decreasing open interest, this may indicate the trend is losing momentum and may not advance much further without difficulty.