Open interest is the number of contracts open (outstanding) in a unique option series. A standard option contract relates to 100 shares, so for example an open interest of 1,019 in a particular option series normally would relate to 101,900 shares (1,019 x 100) of the underlying stock.
Unlike shares of stock, which are finite in number at any one time, there is no theoretical limit to the number of options that can be created in a single series. Put and call options that are currently open can be traded like any other securities, of course. Assume that no contracts of a call series were open and that a trader wants to buy or write that call. When the buy or sell order is entered, if no trader exists on the other side, then a market maker or option exchange specialist must take the other side of the trade – in effect, the market maker acts as the call writer. This is why options can be sold or bought even when there is no open interest already or very little volume.
How Open Interest is Created and Changes:
Unlike the case with stocks, there are four types of option trade orders. A trader must either sell or buy options, and the trade always either opens or closes a position:
- Buy to Open (BTO) – buy an option to create a new long position
- Buy to Close (BTC) – buy an option to close an existing short position
- Sell to Open (STO) – sell an option to create a new short position
- Sell to Close (STC) – sell an option to close an existing long position
When an option is sold to open, it is considered a short position and usually denoted in your trading account with a minus (-) sign.
How Open Interest Increases and Decreases:
- Buyer and Seller both OPEN 1 Contract = + 1 contract (increase)
- Buyer and Seller both CLOSE 1 Contract = – 1 contract (decrease)
- Buyer Opens, Seller Closes 1 Contract = No Change
- Buyer Closes, Seller Opens 1 Contract = No Change
Two opening trades increase open interest, and two closing trades decrease it. When one trade is an open and the other is a close – and it does not matter which is which – open interest does not change.
Open Interest and Liquidity:
Open interest is a key measure of option liquidity, since getting in or out of option positions requires other buyers and sellers. You don’t want your order to move the market! For example, if 70 contracts of a call series are open and you place an order to buy 20 calls, you will either own 20 of 70 open contracts (28%) if existing holders are sell to close, or as little as 20 of 90 contracts (22%) if your order increases open interest. You want to be in a liquid market, not in effect be a market-maker in an illiquid one.
An open interest of less than 2,000 shares indicates fairly thin liquidity; more is better. The higher the open interest, the more professional traders are in the series and the more liquidity exists. Note that open interest is not the sole determinant of liquidity, when the option price is low. Suppose there are 725 contracts open of a particular series on a $50 stock, with a bid/asked quote of 0.25 x 0.30. This means the market value of those contracts is only about $18,125 in total dollars (725 x 100 x $0.25); this is not much liquidity, even though the 725 contracts relate to $3,625,000 of stock (725 x 100 x $50).
The ATM call normally will have the greatest open interest, and when a different strike has the highest interest, it usually means the stock price has changed recently, “stranding” the strike with the highest interest. Sometimes, high speculation on a move will also shift open interest to an OTM strike.