#126 - Does Open Interest Mean Markets Will Go Up Or Down?
Hey everyone, Kirk here again from Option Alpha and welcome back to the daily call. Today, we’re going to answer the question, “Does open interest mean markets will go up or go down?” When it comes to options trading, the real question here is, “What does open interest tell us about the future direction of the market?” Now first, we need to define what open interest is. Really, it’s pretty simple when you think about open interest as opposed to volume. Volume in contract trading for options is just the number of contracts that were traded that day, so what is the volume, how many contracts changed hands. Open interest tells us how many contracts are still left open and working in the market. Now again, there’s got to be basically two parties to the transaction. There’s option buyers and option sellers. Both of these people would have net contracts open or still available in the market. Unlike stock which stock has a predefined amount of shares that you can trade or float, when those shares are traded, there’s nothing else you can do, unless the company issues more stock or issues more shares. In the options market, option contracts are created. People can trade a lot of option contracts since they’re derivatives of the shares. We can have no option contracts traded which some stocks have those. There’s options available. Just no one wants to trade them. And then on the other hand, there can be really, really active periods of time where people want to trade lots and lots of contracts and open interest goes bananas. There’s a lot of people getting in on both sides. When we look at open interest though, open interest increases when people get into new contracts. If I were to buy let’s say 10 Microsoft call options, then that might be the same time that someone else starts a new position to sell 10 Microsoft call options. In that case, that’s a new transaction for everybody. I'm buying, they’re selling or whatever the case is at its new open interest that’s added to the system, so open interest goes up by 10. This would be opposed to somebody doing a trade where it's negated or somebody else has taken the other side of a closing transaction. If I was to again, buy 10 Microsoft call options, but at the same time, I’m matched with somebody else who is selling 10 of their call options, so it’s a sale for them, but they’re selling me theirs, then open interest doesn't go anywhere. It’s already contracts that are out there exchanging one party to the next. The contracts have not been totally closed and liquidated. They’re still out there and available. This is why sometimes we see open interest go up dramatically or go down or stay the same when there’s a lot of volume. Oftentimes, I guess you have questions around this topic come up when people see lots and lots of volume during the day, but open interest basically stay the same and it just means there’s a lot of activity, but not a huge increase in the number of people generally trading or a huge decrease in the number of people generally trading. How can we use this though to determine market direction? Well, we can’t. It really doesn't matter. That's really the crux of what we’re talking about. Maybe people look at open interest and they say, “Oh well. Open interest has dramatically increased, so people are more bullish because call open interest is higher than put option open interest.” But ultimately, we still don’t know where the market is going. We don’t have a clear picture. I always think about it that if there’s a lot of people who are still trading contracts at any strike price, there’s two parties to every transaction. And so, if there's a lot of people who are buying calls, there’s equally as many people who are selling those call options and assuming that the stock never reaches that price point. For me, open interest is not something that I look at all the time to say where the market is going to go, if it’s going to go up or go down. Open interest for me gives me an idea of the depth of a market which is important. I look at open interest and say, “Look. There’s 52,000 contracts that are still open and available. That lets me know that there’s a deep market here, that people are interested in trading this. Bid ask spreads might be low, the ability to get in and out might be pretty quick and so, that’s good for me, that’s good liquidity.” Hopefully this helps out. As always, if you guys have any questions or comments, let me know. Until next time, happy trading!
