What is Open Interest?
Open Interest represents the number of outstanding contracts for an option. If the first trader to trade an option contract purchases 10 contracts, that trader is long 10 contracts and the open interest is 10. If that trader later closes 3 of those contracts, the trader is long 7, the open interest is 7, and the volume is 13. If a different trader sells 4 contracts, the open interest is now 11. The first trader is long 7, the second trader is short 4. The volume is 17.
Open interest is simply the number of outstanding option contracts.
It does not reveal whether option contracts were bought or sold by a retail trader or by an exchange member who may be obligated to fill the retail trader's order. This distinction can be significant, since exchange members have more influence on option prices.
Certain market makers may be obligated to fill option orders, but there is some latitude regarding the price at which orders will be filled. If a market maker is reluctant to fill a buy order, he/she may raise the ask price. The rise in the ask price can signify bullishness on the part of the public. A rise in the option price without a corresponding rise in the stock price results in an increase in a option contract's implied volatility.
Why is Open Interest Significant?A rise in open interest indicates new positions are being taken in a particular contract. If they are call contracts, this may be construed as bullish, particularly if the implied volatility on calls also rises. If open interest is dropping, traders are liquidating option positions, which is not necessarily bearish or bullish.
Regardless of whether open interest is rising or falling, changes in open interest indicate changes in trader's positions. One must assume that the market maker is delta neutral, and filling the public trader's order will force the market maker to readjust his or her hedge. Even though the public trader's trade represents closing a position, and not a bullish or bearish conviction, there is still an impact on the market.
When analyzing changes in option volume, volatility, and volatility skew, it is important to consider changes in open interest. A large volume on option contracts does not necessarily mean there is an increase in interest regarding a stock. If fact, it may mean quite the opposite.