The Story of ‘Open Interest’

 
An innocent question from Dow10k, via Twitter, encouraged my writing a simple post about
  Open Interest.  There's no disagreement on the definition of open interst (OI), but after that, there is so much incredible information on the Internet that writing this post has become more difficult than expected.

First, a definition from our perspective as option traders: Open Interest is the total number of  options (for a specific series) that have been written (sold), but not yet closed. 

Positons can be closed

  • When expiration arrives, options cease to exist
  • When assigned an exercise notice
  • When purchased in a closing transaction.

Open Interest also applies to futures contracts, but there are no assingment notices.  Ownwes of a futures contract take delivery of the undelying asset when settlement (similar to an options expiation date) arrives.

***

The most commonly asked questions concerning OI is "What can I do with the number?"  "How can it help me make trade decisiions?"

Some traders consider OI to be significant and use it as an indicator for technical analysis.

Others, myslef included, remind anyone who wants to use OI, that no one knows whether the option buyer is bullish when buying calls.  It's just as likely to be part of a hedged trade in which stock is being shorted against the calls being bought.  This may be a very bearish play (100 shares sold for each call bought), or a delta neutral, market neutral play.  There is no way to know.  Thus, concluding that call buyers are always bullish and put buyers are bearish is incorrect.  If you accept that argument, then the OI serves no purpose as a market indicator.

Next it matters who enters the buy/sell order because only the seller may cause OI to increase. 

  • If the person initiating the trade (by entering an order) is a seller who is writing (not closing a long position), then OI increases unless the buyers are also closing (by covering a short position in that specific option series)
  • If the person initiating the trade is a buyer, then open interest never increases.  If the sellers are writing, OI is unchanged.  If sellers are closing, then OI decreases

From my perspective, if OI only increases when the trader (not the market maker on the other side of the trade) is selling and never when he/she is buying, how can the OI of any option be considered to be an indicator of market direction? Most technical indicators are based on what buyers are doing.

Here's how I see this problem:  In the futures markets [which started long before options were listed on an exchange (1973)], open interest increases when the trader buys a new futures contract.  Thus, an increase in open interest indiciates buyers are in the market.  And it may (I surely don't know) be a good indicator, suggesting that the bullish trend will continue, when open interest is increasing. 

That is very different from the options world in which only sellers can increase open interest.

***

Consider this statement, made by a professional trader: "Open interest is most often used as an indication of the strength behind the market"  There are only two possibilities:  Either this blogger is mistaken, or he is writing of the futures markets and not the option markets.  Sadly, he claims to be writing about both markets.  This is one example of how bad information is easily spread.  

His is not the only incorrect statement.  I found others, but see no reason to publicize any of them.  Options traders must not only contend with material written exclusively for futures traders, but with the output of thsoe who don't understand the difference between futures OI and options OI.

***

 Wikipedia is the source of the following statement: "If open interest suddenly increases, that suggests a near-term rise in the underlying's volatility."

Once again, I see no reason to believe that there is any valid reason to conclude that an increasing open interest can predict furute volatility.  Why?  Because it's not buyers who initiate the trades that result in an increased OI.  I get the argument:  If a trader anticipates higher volatility, buying options is a smart move.  But it's option sellers who initiate an OI increase.  I fail to be convinced that this is predictive of anything.

***

Wikipedia claims another use for OI:   A leveling off of open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market. Declining open interest in call options implies that the market is liquidating, and suggests that the prevailing price trend is coming to an end.

Once again, I find myself in disagreement. The idea is that buyers, as a group. have stopped loading up on these options, indicating a trend reversal.  The problem is that we NEVER know whether call buyers are truly betting on the upside or whether that are taking bearish positons by hedging.

Again, I'm assuming that these are the writings of a careless contriubutor to Wikipedia.

***

From McMillan on Options

"The best that an outside observer can do is to put together enough information [about OI] to make an educated guess."

 

That feels right to me.  There may be some useful information buried in open interest numbers, but it's not a simple matter to figure out what it is.

809

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15 Responses to The Story of ‘Open Interest’

  1. Henry Tzuo 10/13/2010 at 8:28 AM #

    Hi Mark:
    I totally agree. Another issue is, some are very enthusastic in using “Put/Call ratio” as an indicator of how bullish investors are. In my sense, that’s another mistake. Thera are too many combinations of strategies between options – options, options-futures, options-spot. It is really not that precise in “predicting” how bullishness/bearishness of the dmarket.
    Thanks for the posting.
    Have a great day
    Henry Tzuo

  2. Mark Wolfinger 10/13/2010 at 8:38 AM #

    Henry,
    I must agree. The data seems useful, but you have to know the rationale behind the purchase of puts and calls.
    I agree that much of it is straightforward and what you see is what you get. But the arbs are also playing and I don’t see how volume means much.
    Obviously it means a lot to many intelligent people.

  3. Tyler's Trading 10/13/2010 at 9:34 AM #

    Well done Mark. Perhaps another point worth mentioning regarding Open Interest is its use in gauging liquidity. Typically options with high open interest have tight bid/ask spreads and are therefore more efficient trading vehicles. Those with low open interest often have wider bid/ask spreads making them much tougher to trade.

  4. Dimitris 10/13/2010 at 9:36 AM #

    Mark,
    If, as an example, I want to sell the spead XYZ 100/102 Dec Call and for both 100 Dec C and 102 Dec C the OI is zero, is it possible to make the trade?
    Thanks

  5. Mark Wolfinger 10/13/2010 at 9:50 AM #

    Tyler,
    To be honest, I did not think this point was worth including, but the truth is that this is indeed important.
    It let’s a trader know whether a specific option series (or the entire class) is worth trading.
    Liquidity is important for most strategies (especially if the trader ever wants to get out of a position), and a low open interest suggests that it could be difficult (or costly) to make the necessary trades.
    Personally, I pay no attention to this factor. However, it is an intelligent idea to trade only reasonably liquid options.
    Thanks

  6. Mark Wolfinger 10/13/2010 at 9:52 AM #

    Dimitris,
    The OI does not matter. Yes, you can trade. As with any other trade, all you need is someone who will take the other side
    You must understand: Open interest is ZERO for EVERY option on the very first day that it is listed for trading.

  7. Jeff 10/13/2010 at 5:12 PM #

    Excellent comment Tyler.

  8. Jesse 10/13/2010 at 11:57 PM #

    Another “different” and unique post. Really hope that you can spend some time to prepare an intermediate version of “The Rookie’s Guide”, btw, Mark, can you reorganize your blog contents and publish a new book/ebook?

  9. Mark Wolfinger 10/14/2010 at 6:17 AM #

    Jesse,
    It’s impossible to reorganize blog at this stage.
    However, if you look at the archives, the posts are sorted – to some extent – into categories.
    Would love to do more books, but right now am over-worked with writing commitments.
    I have considered trying to pull the best, most relevant posts into book format, but there is still much new writing needed. Will try to minimize other commitments.
    Thanks

  10. Paulmess 10/15/2010 at 2:00 PM #

    thanks for posting this helpful/useful info
    here are my go-to sites for open interest put/call info (all are free, but may require registration and/or download)
    http://www.schaeffersresearch.com/streetools/stock_quotes.aspx?Ticker=AAPL (using AAPL as an example)
    http://www.crimsonmind.com/options/ActivityWatch.aspx (register for full data sets)
    http://www.samoasky.com/download.html (optionsoracle download)
    you will see from these sites that put/call ratio is a bit more complicated than is first apparent.
    important issues to address are
    > is the ratio relative to ‘daily volumes or current ‘open interest’?
    > are you more concerned with ‘total open interest’ or just for the expiration month of interest (optionsoracle has a great graphing tool to display put/call open interest as a function of expiration date)
    > should you consider ‘dollar-weighted’ values rather than ‘contract weighted’? (i.e., a large volume of deep o-t-m options a/k/a ‘lottery tickets’ could swamp a small number of strategically positioned options a-t-m, unless they were dollar-weighted to reflect the low probability of ‘winning the lottery’)
    lots to think about before you blindly accept put/call ratio data as a trade entry/exit signal.
    know what you trade; trade what you know…

  11. Mark Wolfinger 10/15/2010 at 7:42 PM #

    Thanks PM,
    I hope no one would consider put/call ratio to be anything but a single indicator. Thus, not very valuable unless backed up by other indicators.

  12. primera furniture 10/17/2010 at 10:32 AM #

    Some people say the market movers move the stock market is the direction which they have to pay the least amount of money to option traders in 3rd Friday the month. I try to use Open Interest in option to make sense of market. Is this true?
    -Miyaka

  13. Mark Wolfinger 10/17/2010 at 2:26 PM #

    Miyaka,
    I do not believe this is true. Not everyone agrees.
    1) They do not pay the ‘market makers.’ Many times it’s not the market makers who own the options that are in the money.
    2) I don’t believe there are ‘market movers’ at play when expiration arrives – at least not on a Friday afternoon.
    However, it does seem to me that the ‘fix is in’ and that Friday morning settlement of index prices, such as RUT, SPX, and NDX are manipulated. However, as much as it appears that way, I don’t see how it is possible unless ‘market movers’ get together and agree whether to move markets higher or lower.
    I don’t see how ‘they’ could agree to do that. First, it against the law, and I suspect it would be too easy to get caught by repeatedly taking the action necessary to achieve the desired results.
    Second, it’s highly unethical – but in today’s world, too few people care about that.
    Third, it’s very risk to attempt to become such a market mover when other such market movers may be operating in the opposite direction.
    Bottom line: It appears to be happening – but I believe it’s an illusion and that the reply to your question is ‘no.’
    But I admit – I am not certain.
    Good question. I wish I had a better reply.

  14. Mark 10/18/2010 at 8:36 AM #

    Mark –
    I agree with the main point of your post, which is that Open Interest is neither a directional indicator nor a volatility indicator. However, I am having trouble understanding how OI has anything to do with the different actions of a market maker vs a non-market maker. Let me state my viewpoint, and perhaps you can help me see where I misunderstand you.
    For the purposes of OI calculations, there is no difference between a retail trader and a market maker. Thus, it doesn’t matter what the retail trader does; what matters is the positional effects of every trade on both participants’ accounts. For my evidence I submit the following two degenerate cases, wherein this is the first trade ever made in an options product. I think we can all agree that on the first day of trading, prior to the first trade, the open interest is 0.
    Case #1: Starting open interest is 0, everyone is flat. Market maker quotes bids and offers. Retail trader comes along and sells/writes a contract, hitting market maker’s bid. Open interest increases to 1 because market maker’s position increased to +1, and retail trader’s position increased to -1.
    Case #2: Starting open interest is 0, everyone is flat. Market maker quotes bids and offers. Retail trader comes along and buys market maker’s offer. Open interest increases to 1 because market maker’s position increased to -1, and retail trader’s position increased to +1.
    We can also come up with situations where a retail trader is not the trade initiator: i.e. he works a bid and the market maker’s quoted market decreases throughout the session, eventually crossing with the retail bid and filling it. In fact, I could easily iterate through all possible combinations of initiating, buying/selling, and positional effects.
    I submit that the following rules are more accurate to define how open interest behaves:
    1. If both participants’ positions increase as a result of the trade, then open interest increases.
    2. If both participants’ positions decrease as a result of the trade, then open interest decreases.
    3. Otherwise, open interest is unchanged.

  15. Mark Wolfinger 10/18/2010 at 5:22 PM #

    Mark,
    I like your defining rules. Simplicity trumps all else.
    Thanks