What is open interest?

Open interest refers to the total number of outstanding futures or options contracts in a market. It reflects the current trading activity and speculative behavior in the market.

When a futures or options contract is established between a buyer and a seller, the open interest increases. When these contracts are closed, the open interest decreases. Therefore, open interest can be seen as the number of unsettled contracts in the market.

Open interest is an important indicator as it can help analyze the trading activity and speculation in the market. A higher open interest typically indicates more active trading and higher speculation, while lower open interest may indicate a lack of confidence in the market sentiment and trend.

At the same time, open interest can also be used to determine market liquidity and price trends. For example, in a market where the open interest increases and the market price rises, this may indicate an increase in buying pressure, leading to a price increase. Conversely, if the open interest decreases and the market price falls, this may indicate an increase in selling pressure, leading to a price decrease.

People often say that there are "more buyers" or "more sellers" in a particular market, but this is not accurate.

For Open Interest, it's important to understand that every buyer must have a seller, and vice versa.

To illustrate this, let's say there are three traders who meet in a newly established market with an Open Interest of 0 and a price of $100.

Trader A thinks the market will go up, while Trader B thinks it will go down.

Trader A places a limit buy order at $100, and Trader B decides to match the buy order and open a short position.

At this point, the Open Interest of the market becomes 1 due to a long and a short position being opened at the same time.

The market goes up to $150, and Trader C also decides to take a long position.

At $150, Trader A decides that $50 profit is enough and places an order to sell one of their contracts. Trader C matches this order and now holds a long contract.

Has the Open Interest changed? No.

We have one long position exiting (remember, you become a short when you sell an opening position), and one long position entering the market.

The market continues to go up, and at $200, Trader B decides to exit.

Trader B places a limit buy order at $200, and Trader C decides to match the order for a $50 profit.

In this case, both Trader B and Trader C exit their positions, and the Open Interest drops back down to 0.

In this example, you can see that there are three possible outcomes for Open Interest.

If both buyers and sellers increase, Open Interest will increase.

If both buyers and sellers close their positions, Open Interest will decrease.

If one side opens new positions while the other is closing their positions, Open Interest remains the same.

So why does the underlying asset price change when every buyer must be a seller (and vice versa)?

One of the reasons why trading in most markets is relatively easy is that there are market participants who are Delta-neutral.

These individuals are called market makers.

No, they're not evil entities manipulating prices. They create the market by providing liquidity.

In summary, open interest is an important indicator in the futures and options market, and it can help analyze the trading activity, speculation, liquidity, and price trends in the market.