Open interest is challenging to dissect

Open interest is challenging to dissect. A common mistake among new traders to options is to
consider open interest as the same as the number of option contracts traded. Both a "sell to open" and
"buy to open" position can but will not necessarily increase open interest. Similarly, "sell to
close" and "buy to close" can but will not necessarily decrease open interest. When an option is
traded with one party opening and one party closing, the open interest remains unchanged. If both
parties in the transaction are closing positions then the open interest decreases. If both parties are
opening positions, then the open interest goes up. There is no way to exactly determine how many
"sell" and "buy" positions or trades are executed, only the net total open interest amount. Like
volatility, it has no directional component, it is just an end of day tally of unsettled contracts.

Open interest is calculated centrally on an end-of-day basis by the Options Clearing Corp (OCC) for US
options. The next morning, Open interest is displayed on the OCC web site but it is not distributed
industry-wide until the next business day morning. The impact of this difference is felt over the
weekend when the OCC web site is showing Friday's open interest but other financial sites are showing
Thursday's open interest. For the rest of the next trading day the open interest figures remains static.
Open interest can vary from the call side to the put side, and from strike price to strike price.

Open interest is an especially important metric for market makers and professional traders. It provides
insight in helping to choose which option strikes to trade, for example in executing dividend capture
strategies. A large cluster of open interest around strikes can be interpreted as a possible trading
opportunity and can signal a stock price pin at expiration. If a break in stock price occurs
through a large open interest at a particular strike, the move can be magnified by forcing hedges
and stop losses on option positions as the stock breaks through the strike prices.

High Open Interest can also be viewed as an indicator supporting current market moves or
committed positions that are investment bets on future stock outcomes. Additionally, traders may
further parse high open interest to specific expiration, strike and option type to assess what the order
flow is actually targeting, and track the performance and implied volatility of that specific option.

By analyzing the changes in the open interest figures at the end of each trading day, some
conclusions about the day’s activity can also be drawn.

Increasing open interest is an indication that new investment is flowing into the market. The
result will be that the present market momentum (up, down or sideways) is likely to continue.

Declining open interest indicates the market is closing positions (liquidating) and implies that the current
price trend may be coming to an end. Knowledge of open interest can also be useful toward the end of
major market moves. A leveling of open interest following a sustained price advance is often an
early warning sign of an end to an upward movement in the market. However, neither an increase
in volatility nor open interest necessarily indicate anything about the direction of future price movements.

It is important to note that high open interest for a given option contract means there is high interest
in that option, but it does not mean that those trading the contract have the same or a correct
forecast on stock movement. For every option buyer who expects one result, there’s an option seller
expecting something else to happen. Open Interest and Put/Call Ratios can be revealing indicators of
how option traders and order flow are moving. Some investors consider put/call ratios as a contrary
indicator because these metrics reach extremes at the height of an emotional trading event.
Others may view this as a build up to a bigger and longer momentum play. The metrics can be used in
combination with other statistics to gain an insight into order flow sentiment.