Open interest trading strategy
While calculating open interest is quite simple in theory, the application is often a bit more confusing. Stockholder Adam writes six call contracts for SPY as he thinks it will go down, and he wants to collect option premium. Trader Bob purchases one call contract as he thinks SPY will go up. Trader Cathy buys the remainder of the call contracts. The next day, SPY moves up. Bob exercises his contract with Adam and purchases SPY at a discount.
Adam still collects the option premium but no longer holds the SPY associated with that contract. Cathy, on the other hand, sells all five of her in-the-money contracts to Dave. Even though every contract was traded, open interest fell by one as no new contracts were created, and one was settled. On day three, SPY moves down big.
The options expire worthless. Dave loses all of the money he used to purchase the options from Cathy. Traders often hold on to contracts for more than a day or two, the numbers in real life are considerably higher, options expire at different times, and option types are tallied separately, as seen in the open interest chart below.
This example does help convey the complex nature of calculating open interest and how open interest may stay low, while volume increases.
This is useful for any trader, but especially trend following traders seeking to find and profit from market trends. When open interest increases, more money, and interest are coming in, which most market technicians believe helps the current trend to continue. When open interest decreases, this means traders are leaving and taking their money with them. This may be a sign that a trend reversal is about to occur. The larger and faster the change in open interest in either direction , the stronger the indicator.
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There is, therefore, no guarantee that a specific trend will abide by the rules of these patterns. When using open interest in conjunction with price to predict trends, there are four main interpretations. Remember, when open interest increases, it is generally considered an indication that a price trend will continue on its current trajectory. That is because the decrease in open interest shows that the money and interest fueling this trend have begun to decrease. Open interest is an incredibly useful tool for gauging changes in buying and selling pressure in the market.
Trading on the information content of open interest can be profitable. The key to getting the most use out of it, though, rests on using it in conjunction with other indicators, primarily price and volume.
Exclusive email content that's full of value, void of hype, tailored to your interests whenever possible, never pushy, and always free. Open Interest Increases and Price Increases 2. Open Interest Decreases and Price Increases 3. Open Interest Increases and Price Decreases 4. The process for derivatives is a bit different.
An Explanation of Open Interest Open interest is the number of derivative contracts that have not yet been settled.
Open Interest. How to use it in trading?
Calculating Open Interest Open interest is merely the total of all open contracts. In the options and futures markets, open interest represents the total number of contracts at the end of the current day which are not closed or delivered, thus the number of existing contracts. In the stock market, it reflects the number of buy orders submitted before the market opens. It is a common misconception that volume and open interest are the same. Open interest changes when new traders enter the market or old ones leave it, because their trade creates a new contract or closes an old one.
For example, if the open interest in July silver futures traded on the Comex division of the NYMEX is 5 , then 5 contracts are held by bulls and by bears. If that number jumps to 5 , it means that new contracts have been bought and sold short.
Open Interest Strategy And How To Use It - Traders-Paradise
Conversely, if open interest falls to 4 , it means that bulls have closed long positions, thus sold, while bears covered their shorts, thus bought. If a new bull enters the market and buys a contract from an old bull, then open interest remains the same because the number of contracts has not changed, they have just changed their owner. The same logic is in force for bears.
Open interest illustrates the intensity of the battle between bulls and bears. The higher the open interest, the stronger the disagreement between the two counterparts is as both bulls and bears are willing to maintain their long and respectively short positions. When either one of them reach to a conclusion the market wont move in their desired direction, they will logically close out positions and open interest will decline.
As bulls and bears battle each other, one of the sides is bound to lose, but as long as there is a steady stream of potential losers coming in the market, the trend will continue. Rising open interest means that the number of losers is rising. In a bull trend, for example, rising open interest implies that bulls are buying, while shorts are selling since they are convinced the market has reached a high level and will soon reverse. However, as soon as losses become unbearable, they will cover their positions, thus buy, which will shoot the market even higher.
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However, if no new shorts enter the market, the trend is bound to exhaust soon enough. This means that rising open interest during a trend is favorable for its development and implies it will continue. The same logic is in force for bear trends. If a bull wants to buy, but there is no bear who wants to sell, the only possible way for him to procure a contract is to buy from an old bull, who has previously bought lower and now sells higher. In this situation open interest remains the same as no new contract has been created, it is just switching owners.
If open interest remains flat during a trend, it suggests that the number of losers has stopped increasing. The same logic applies for downtrends. The last possible scenario is for open interest to decline.