The stock market is full of jargon, and this is especially true if you’re in the options market. One of the key terms to know in the options market is open interest. Here’s why that’s important.
Open interest is the total number of contracts that exist on a given day. In that sense, the closest analogy in the stock market is outstanding shares. However, while outstanding shares are typically relatively stable, open interest in the options market can fluctuate on a daily basis.
Open interest is different from trading volume because trading volume represents the total number of shares of stock that change hands on a given day. Open interest, on the other hand, only changes when new contracts are created or closed.
The reason why the options market needs a measurement of open interest and the stock market doesn’t is because stock traders don’t actually create or destroy shares of stock. However, option writers are creating new contracts, and option sellers can close or liquidate a contract. Options traders can open or close a contract when either buying or selling, which is why options trade orders ask traders to specify whether the order is “to open” or “to close.”
At the end of the day, the Options Clearing Corporation (OCC) comes in and tallies up all the orders marked “to open,” subtracts all the orders marked “to close” and then updates the overall open interest for the remaining options on a particular stock or a particular contract.
Volume tells traders where the action is, but open interest tells traders which prices the market sees as the most important levels. Contracts with large open interest have the highest liquidity and may be easier to trade and have narrower spreads than contracts with lower open interest.
Open interest also matters to traders who subscribe to certain trading strategies, such as the “max pain” theory. The max pain theory suggests stocks tend to trade toward the price that has the highest total put and call open interest, inflicting the maximum possible pain on option buyers. If a stock closes at a particular strike price on an expiration day, all the put and call options for that strike price will expire worthless.
One thing options traders need to understand is that open interest doesn’t necessarily convey useful information about market sentiment. Much like every stock trade has a buyer and a seller, every open option contract has a trader on either side expecting two different outcomes. Just because a particular contract has a much larger open interest of calls than puts doesn’t mean that the majority of traders see the stock heading higher.
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