In the financial markets, there are two of the most essential indicators that you as a trader employ for trading, namely, open interest and trading volume. Both of these are necessary when trying to determine how active and liquid a particular market is and especially in markets involving futures and options.
Although they seem very close when viewed superficially, they entail different meanings and implications for market players. Open interest and trading volume are unique insights into the thought process in a market, trend strength, and liquidity. Knowing the differences between these two metrics may give a serious edge to traders to predict price movements and make fairly informed trading decisions.
We are going to talk about the open interest concept, to define it, to find out its calculation, and describe the meaning of the concept. Then, we are going to analyze how this can express a view concerning the market.
Furthermore, we are going to compare open interest and trading volume because of how these metrics express various features of the activity on the market. At the end of this article, you will have an in-depth understanding of how to read open interest alongside trading volume, and therefore how to use the two together toward improving your trading strategies.
What is Open Interest?
The amount of unsettled, unmatched or even exercised contracts that exist at a given time in the market is the definition of open interest. In other words, it includes the options, futures, or sometimes other derivative contracts. Open interest gauges the amount of contracts outstanding and hence available with the participants of the market; it denotes a count of all such positions that have been left open with the market so far and do not represent close offsetting.
Unlike the trading volume, which would indicate the number of contracts traded within a given period, open interest presents a view from afar about market activity. This would give a trader the sense of commitment and liquidity as a whole, for open interest informs one of the number of contracts that are still outstanding in the market.
How to Calculate Open Interest
One may simply apply the following simple formula to calculate open interest:
• Open Interest = (Contracts Purchased) – (Contracts Sold)
• It gets added each time the contracts number goes up with a fresh purchase or sell
• If it is closing where two opposite contracts level each other then, the count will go down.
It does hint towards the participation of the market where, through levels, gives room for further decisions to make regarding further movements.
How Does Open Interest Work
New positions increase open interest. If a trader buys a call option from another trader selling it, then that increases the open interest in that particular option. The same goes with a futures contract; if someone buys a futures contract, the seller will take an opposite position in that.
Instead, open interest will fall when there are open positions to be closed. This can happen in two scenarios: that is, when the trader is closing an existing short position for a stock or when he is closing an existing long position for the same.
This actually describes how much capital a market participant can commit to any given contract. High open interest means a big number of people are participating and trading, but low open interest means the absence of active involvement and interest for that contract.
Importance of Open Interest
Open interest is a very important tool for traders since it may reveal some insights regarding the market trends, liquidity, and sentiment. Here’s how:
1. Increasing open interest in an uptrend
If the open interest is rising in an uptrend, it is taken as one of the strengths of the trend, since it signifies that new entrances of traders into the market have resulted in creating new positions. A declining open interest in an uptrend means that the trend is losing its pace since the traders may close their positions.
2. Liquidity:
A big part of the liquidity of any contract is through open interest. The greater the open interest in a given contract, the more liquid that is, therefore an easier market into which to step in and get out of position without moving prices too much.
3. Continuation or Reversal Indications:
A trend may have a continuation sign or a sign of reversal indicated by open interest. For example:
o Increasing open interest in a rally: It is a good sign that the rally will continue since new buyers are entering the market.
o Increasing open interest in a breakdown: It means that the downtrend will continue since more short positions are being set up.
o Decreasing open interest in price movements: It is the sign of losing interest in the market and possible turnaround.
What is Trading Volume?
Volume refers to the number of contracts, or shares in the case of stocks, traded in a period, usually measured on a daily basis. Volume indicates the volume of activity carried out in a market and thus is one of the most significant interest indicators for the markets. A great deal of trading volume often reflects a high volatility, but low volume often signals a lack of interest and even stagnation in the market.
Calculation of Trading Volume:
Coverage is the total figure of contracts signed over a given period of time. For example, if one futures investor purchases one contract and another futures investor sell another type of contract within the same trading session, that entails one business unit of volume. Every trading session resets volume. In fact, it can be found as a bar in most price action charts at the bottom.
Importance of Trading Volume
Volume is one such indicator that reflects the strength of a price movement. It establishes the market’s involvement and verifies the price movement.
1. Market Momentum
Whenever the price movement is moving in one direction, the volume of the price movement is measured. An upward-moving price with high volume indicates heavy buying interest. The downward price with high volume is said to indicate heavy selling interest.
2. Price Reversals:
Volume also becomes a tool in the search for potential price reversals. Extreme price moves that are accompanied by very low volumes are a good indicator that the trend is weakening and is close to reversing. A price reversal accompanied by increasing volume often shows that the reversal is real, and market psychology is changing.
3. Liquidity:
Like open interest, high volume generally tends to mean higher liquidity that should translate into more smooth and less volatile price movements. Low volume generally tends to coincide with illiquidity markets where price movements become exaggerated or erratic.
Open Interest and Trading Volume
Even though open interest and trading volume are used together, they tend to give the user different information on the market.
• Open interest is an amount of outstanding contracts. That represents how much long-term commitment to any given position as well as to a general condition of a trend. Open interest, therefore, can be called a measure of the market’s mood; consequently, if this one increase or falls, strength in the trend is indicated.
• Trading Volume is the level of market activity in terms of trading during a period. It can be thought of as a medium-term measure of market involvement, detailing the intensity of a price move and immediate interest in a specific contract or market.
Together they create an entirely balanced view of the activity in markets. Volume shows the short-term interest in the trades; open interest presents a far more significant and longer-term interest. Together they can be supportive of confirming trends, detecting reversals, and finally gauging overall market sentiment.
Open Interest Used with Volume for Interpretation of Market Movement
There should be a try to attempt to make sense of the phenomenon of open interest and volume, analysing the way it correlates to a price movement.
1. Increase in Volume Along with Increasing Open Interest:
This is a very strong indication of either going bullish or going bearish in the market. It depends on whether the prices are moving up or down. A new position opened and increased market participation are implications of this one. The established trend will very likely be continued.
2. Increasing Volume along with Decreasing Open Interest
This can be close position where, yes, there is still trading but the traders are closing positions and taking profit or even stop-loss as the trend has started to lose some of the strength it initially possessed.
3. Decreasing Volume and Declining Open Interest
This indicates non-participation in the market. Probable consolidations or in a range-bound move. A sign of stagnation, one must be very careful before trading.
4. Falling Volume and Increasing Open Interest:
Somewhat of an odd pattern this might take during choppy markets. The signs that are usually seen by a trader indicating people are holding onto it but still volume not too big enough to support and authenticate the trend.
Conclusion
The open interest and the trading volume are, thus, two instruments of utmost importance in understanding market behavior, although what they tell are of different natures.
The open interest quantifies the number of outstanding contracts; that is, it points to the depth of market involvement and long-run patterns. The trading volume reflects the degree of action in a certain period and hence the intensity of price action.
Traders should use open interest and volume together to realize whether the market exhibits a sentiment, provides liquidity, and price movement; hence, if these metrics, if read correctly, will help traders choose stronger trends in markets, reevaluate the ability for reversals, and create underlying forces behind price action, which will basically make a trader in the non-ending fluid world of financial markets better at getting informed decisions coupled with risk management.
FREQUENTLY ASKED QUESTIONS
1. What’s More Relevant, Volume or Open Interest?
Volume and open interest are both very crucial statistics, always relative to the trade and peculiar market conditions:
• Volume is a short-term view of market activity and the level of participation in the market. This is highly crucial in establishing trends and the price movements’ strength.
• Open interest is the total number of open contracts and can be used to measure long-term sentiment and liquidity. It is important in understanding the sustainability of a trend. In other words, neither is more important than the other; they complement each other. Volume gives insights into short-term market movement, while open interest provides a longer-term view of market participation and sentiment.
2. What is Open Interest and Trading Volume?
• Open Interest (OI): It is the number of outstanding, unsold contracts-options or futures. At every opening of a new position, open interest increases and at closing of a position decreases. OI is one of the very important determinants in establishing the liquidity and market sentiment.
• Trading Volume: The total of contracts or shares traded in any given time space, usually done on a per-day basis. Volume gives the level of action inside a market to assist in inferring whether some price movement does indeed have any major market action support.
3. What Is the Difference between OI and Change in OI?
• Open Interest (OI): OI represents the total no. of active positions in a given market at a particular point.
• Change in Open Interest (Change in OI): OI change between the two consecutive sessions. Positive Change in OI means new opens, and change in OI is negative: it means one is closing, or liquidation.
4. LTP and OI in the Option Chain.
• LTP: LTP represents the price where the latest trade of an option contract was executed. This is the current market price for the option.
• OI: In an options chain, it is the aggregation of open contracts that are not squashed. Thus, it describes the participation level and liquidity associated with a strike price in the options market.
5. How to Choose CE and PE?
While choosing Call Options (CE) or Put Options (PE) the following factors are to be considered:
• Market Outlook: If you think that the price of the underlying asset will rise in the near future then select CE (Call Option). If you think that it would decline, then select PE (Put Option).
• Strike Price Selection: Select the strike prices aligned with your expectation about the direction of the market. At-the-money options, whose strike price is near the prevailing market price, are usually more liquid and cheaper. Options OTM may present a higher reward if the market makes a sharp move.
• Implied Volatility: The higher the option premiums, generally, you expect if you can see high implied volatility. And if you get a feeling for large price movement, then you’re going to be in options with high implied volatility.
• Time to Expiration: The more the time value, the more significant the expiry times, since when the expiry times come, there is ample chance for the market to move into the target price of the expiry times. The high risk that presents itself should see faster returns go to those of a shorter expiry.