Trading Open Interest

Open interest is the number of open option contracts in a specific series that must be closed out by the expiration date. A “series” being defined as options with the same underlying stock, type (either a call or a put) same strike and expiration.

Open positions can be closed prior to expiration when one executes a closing buy or sell order. At expiration all option positions are closed either because the options expire worthless or in-the-money options are exercised.

Open interest can vary as a result of daily trading activity. Although a large volume day does not necessarily translate into a change in the open interest. Open interest will rise when an opening buy order is matched with an opening sell order. Open interest will decline when a closing buy is matched with a closing sell order.

For clarity, suppose you own 1000 shares of XYZ and decide to sell ten July 20 calls against the shares. Since you do not currently hold any XYZ options you are said to be initiating an opening sale of 10 call option contracts.

On the other side is an investor who is buying the XYZ July 20 calls. The call buyer is anticipating a significant rise in the value of XYZ shares and executes an open buy transaction. When the options clearing corporation matches the opening sale with the opening buy, the open interest in the XYZ July 20 calls rises by ten contracts.

If you decide to re-purchase the calls prior to the July expiration you would enter a closing transaction to buy back the 10 short calls. On the other side of this trade may be an investor executing an opening sell of 10 XYZ July 20 calls. In this example we have matched a closing buy with an opening sell, the positions cancel each other and open interest remains the same.

Finally we could have a closing buy with a closing sell. In this scenario open interest declines by the number of contracts traded. Open interest is calculated by the option clearing corporation (CDCC) as it matches opening a closing orders.

Traders can use open interest to assist in finding the right strike for a particular market scenario. Buying a call, for example, requires one to choose the right expiration cycle and the right strike.

If you have a bullish bias on XYZ over the next couple of months you could buy XYZ August calls. Selecting a particular strike usually hinges on one’s expectation for the underlying stock. Assuming a specific target for XYZ then buy the strike that will produce the best return under that scenario.

Another approach is to use remnants of efficient market theory to select the right strike. In other words having selected the expiration month look for the option series with the highest open interest. Assuming the underlying stock has a large following among option traders, the strike with the largest option interest is often the right strike to buy.

Where there is a large open interest, the series will tend to be more liquid making it easier to enter and exit positions at a reasonable price.

Typically the at-the-money strike has the largest open interest across all expiration cycles. When that is not the case the market may be telling us something. If XYZ is trading at $20 per share and the largest open interest is at the $25 out-of-the-money strike, traders may be expecting the stock to advance sharply because of an unexpected company specific event.

Obviously open interest is not the only tool one should use. It is however, another tool that when understood can help with your decision making process.