Understanding open interest is crucial for making informed decisions and devising successful trading strategies in options trading. Open interest represents the total number of outstanding or open options contracts in the market for a particular strike price and expiration date that have not been closed or exercised.
In this comprehensive guide, we will delve into the concept of open interest in options trading, exploring its significance, interpretation, practical applications and much more. Moreover, we will demonstrate how Python can be used for analysing and interpreting open interest data, providing traders with valuable insights and tools to enhance their decision-making process.
This blog covers:
- Overview of options trading
- What is open interest in options trading?
- Real-world examples of open interest in options trading
- Types of open interest in options trading
- What is the significance of open interest in options trading?
- Relationship between open interest and price
- Using open interest in options trading with Python
- Misconceptions about open interest in options trading
- Challenges surrounding open interest in options trading
- How to overcome the challenges of using open interest?
Overview of options trading
Options trading is a form of derivative trading that enables traders to participate in the price fluctuations of an underlying asset without the necessity of owning it outright.
In options trading, traders can buy or sell options contracts, which grant them the right, but not the obligation,
- to buy (call option) or
- sell (put option) the underlying asset at a predetermined price (strike price) within a specified period (expiration date).
You can explore the course on options trading course by Quantra.
Key concepts of options trading
Some of the key concepts of options trading are:
- Call options: Call options give the holder the right to buy the underlying asset at the strike price before the expiration date.
- Put options: Put options give the holder the right to sell the underlying asset at the strike price before the expiration date.
- Strike price: Strike price is the price at which the option holder can buy or sell the underlying asset.
- Expiration date: The date by which the option contract must be exercised is called the expiration date.
- Premium: The price paid for the option contract is called the premium.
Why should one do options trading?
Options trading offers several advantages, including:
- Leverage: Options allow investors to control a large amount of the underlying asset with a relatively smaller amount of premium.
- Risk management: Options can be used to hedge against potential losses in a portfolio.
- Income generation: Options trading strategies can be used to generate income in both bullish and bearish market conditions.
Options trading strategies for beginners can seem like a daunting task. Having had said that, with the video below, as a beginner you can find out some beginner friendly options trading strategies.
Risks of options trading
While options trading offers significant opportunities for maximising returns, it also involves risks which we will discuss in detail ahead in the blog.
Moving to the open interest in options trading, let us find out what it means and some key points regarding the same.
What is open interest in options trading?
Open interest in options trading represents the number of contracts that have been initiated and are still open or not yet closed out by an offsetting trade or have not been exercised.
Unlike volume, which measures the number of contracts traded during a specific period, open interest provides insight into the depth of market interest in a particular option contract.
Key concepts of open interest in options trading
- Total contracts: Open interest represents the total number of options contracts that are currently held by traders and investors.
- Unsettled contracts: These include contracts that have been opened (bought or sold) but not yet closed out by an offsetting trade or exercised.
- Market interest: Open interest helps traders and investors gauge market sentiment and the overall level of interest in a particular option contract.
Understanding open interest is crucial for analysing market trends, identifying potential price movements, and developing effective options trading strategies.⁽¹⁾
Let us move to real-world examples of open interest in options trading.
Real-world examples of open interest in options trading
Let us see some real-world examples taking the references from the news of 2023 - 2024 and also the example of earnings announcement.
Open interest in options trading: Example 1 - Tesla Stock (TSLA) Calls and Open Interest
Let's imagine you're interested in Tesla (TSLA) stock and considering buying call options. Call options give you the right, but not the obligation, to buy the stock at a specific price (strike price) by a certain date (expiry).
Scenario: Tesla recently announced a new battery technology that analysts believe will significantly boost the company's future. You suspect the stock price will rise in the coming months.
Open interest analysis:
- As you check for the open interest for TSLA across the expiry dates and strike prices, you may get some conclusions. In this example, let us assume that the open interest for TSLA call options with a strike price of $1000, which is expiring in 3 months, has significantly increased in the past week.
Interpretation: This rise in open interest suggests a growing number of traders are buying TSLA call options. This could indicate:
- Bullish Sentiment: Many traders will be betting on a price increase for TSLA, supporting your bullish analysis.
- Increased options activity: The rise in open interest might simply reflect more traders entering the options market for TSLA, but not necessarily a definitive direction.
Open interest in options trading: Example 2 - Earnings Announcement for Apple (AAPL)
Scenario: Apple (AAPL) is about to report quarterly earnings. You're unsure if the stock price will rise or fall after the announcement.
Open interest analysis:
- You may observe that there is a significant increase in both call and put open interest for AAPL options expiring shortly after the earnings report.
- Interpretation: This high open interest in both directions suggests uncertainty surrounding the earnings outcome. Traders are hedging their bets by buying calls (expecting a price increase) and puts (expecting a price decrease).
- Decision: Due to the conflicting open interest signals, relying solely on open interest might not be ideal. It's best to combine this information with technical analysis or earnings estimates for a more informed decision.
Now we will move forward with the topic and find out about types of open interest in options trading.
Types of open interest in options trading
In options trading, open interest can be classified into three main types based on its behaviour:
Increasing open interest
- When the number of open contracts for a specific option increases, it indicates that new positions are being created.
- Increasing open interest suggests that market participants are showing interest in that particular option, indicating potential bullish or bearish sentiment depending on whether it's a call or put option.
Decreasing open interest
- When the number of open contracts for a specific option decreases, it suggests that existing positions are being closed out.
- Decreasing open interest may indicate a lack of confidence among traders, signalling potential market indecision or a reversal in trend.
Stable open interest
- When the number of open contracts for a specific option remains relatively unchanged over time, it suggests that the market sentiment has not significantly shifted.
- Stable open interest may indicate that the current trend is likely to continue, or it may suggest a period of consolidation before a potential breakout or breakdown.
Understanding the behaviour of open interest is essential for analysing market sentiment and making informed trading decisions. By monitoring changes in open interest, traders can gain valuable insights into potential price movements and market trends.
Now we will see the significance of open interest in options trading and learn why open interest is preferred.
What is the significance of open interest in options trading?
The significance of open interest in options trading lies in its ability to provide valuable insights into market sentiment, liquidity, and potential price movements. ⁽¹⁾
Here are some key reasons why open interest is important:
Market Sentiment Analysis:
- Open interest reflects the number of open or outstanding options contracts in the market.
- Increasing open interest suggests growing investor interest in a particular option, indicating potential bullish or bearish sentiment.
- Decreasing open interest may indicate waning investor interest and potential market indecision.
Liquidity Measurement:
- High open interest levels indicate high liquidity for a particular option, making it easier for traders to enter and exit positions.
- Low open interest levels suggest lower liquidity, which may result in wider bid-ask spreads and increased trading costs.
Price Trend Identification:
- Changes in open interest can help traders identify potential trend reversals or continuations.
- Increasing open interest along with rising prices may indicate a strengthening trend, while decreasing open interest alongside price increases may signal a potential reversal.
Going forward, we will discuss the relationship between open interest and price in order to increase the clarity on the topic.
Relationship between open interest and price
There are three possibilities when it comes to open interest and price, and these are:
- Positive relationship: Increasing open interest along with rising prices may indicate a strengthening trend. It suggests growing investor interest and potential trend continuation.
- Negative relationship: Decreasing open interest alongside price increases may signal a potential trend reversal. It suggests waning investor interest and potential trend weakness.
- Indication of support and resistance: High open interest at a specific strike price may act as a magnet for the underlying asset's price. It can help identify key support and resistance levels as expiration approaches.
Let us see the use of open interest in options trading with Python.
Using open interest in options trading with Python
(Credit for the code: Akshay Chaudhary)
Step 1: Import libraries
Start by importing the necessary Python libraries for data manipulation and visualisation.
Step 2: Fetch data and print
Read the CSV files containing the March and April contracts for SBIN, and print the tail of each dataframe to inspect the data.
Output:
Expiry_Date Option_Type Strike_Price Symbol Close OI Date 21-Mar-2024 28-Mar-2024 CE 800 SBIN 0.50 11016000 22-Mar-2024 28-Mar-2024 CE 800 SBIN 0.30 9654000 26-Mar-2024 28-Mar-2024 CE 800 SBIN 0.10 8464500 27-Mar-2024 28-Mar-2024 CE 800 SBIN 0.05 6808500 28-Mar-2024 28-Mar-2024 CE 800 SBIN 0.05 6636000
Output:
Expiry_Date Option_Type Strike_Price Symbol Close OI Date 19-Apr-2024 25-Apr-2024 CE 800 SBIN 0.45 8062500 22-Apr-2024 25-Apr-2024 CE 800 SBIN 0.45 5406000 23-Apr-2024 25-Apr-2024 CE 800 SBIN 0.45 5134500 24-Apr-2024 25-Apr-2024 CE 800 SBIN 0.15 4023000 25-Apr-2024 25-Apr-2024 CE 800 SBIN 12.10 745500
Step 3: Concatenate the columns of OI and visualise open interest (OI)
Combine the 'OI' columns from both dataframes and visualise the total Open Interest and its 5-day moving average.
Output:
The plot of Open Interest (OI) from the combined March and April contracts, along with its 5-day moving average, shows fluctuations in trading activity over time for SBIN's 800 Strike Price option contracts.
Two types of OIs in the output above are-
- High OI (peaking on 15th March for March 2024 and 16th April for April 2024) indicates increased trading activity and market interest, suggesting anticipation of significant price movements.
- Low OI (lowest on 1st April 2024) suggests reduced activity. The 5-day moving average smooths out short-term fluctuations, providing a clearer view of the overall trend and helping to identify periods of momentum and potential reversals.
Step 4: Concatenate and Visualise Close Prices
Combine the 'Close' columns from both dataframes and create a continuous 'Close' price column. Visualise the close prices and their 5-day moving average.
Output:
The plot of the continuous 'Close' price above, created by merging the close prices from March and April contracts, shows price movements over time for SBIN's 800 Strike Price option.
This continuous price column allows for seamless tracking of price changes, highlighting periods of volatility and stability. The 5-day moving average smooths out daily fluctuations, offering a clearer view of the underlying price trend and aiding in the identification of sustained movements and potential trend reversals.
Next, we will see the common misconceptions about open interest in options trading. Knowing about these misconceptions will help you be aware of what not to spend your time and effort on.
Misconceptions about open interest in options trading
Below we will see the common misconceptions and the realities of open interest in options trading to make the understanding better.
|
Misconception |
Reality |
|
High open interest indicates bullishness, low open interest indicates bearishness |
Open interest alone does not indicate market direction. High open interest could mean either bullishness or bearishness, depending on the context. |
|
Open interest and volume are the same |
While both open interest and volume reflect market activity, they measure different things. Volume measures the number of contracts traded during a specific period, while open interest represents the total number of outstanding contracts. |
|
Changes in open interest always predict price movements |
Changes in open interest should be interpreted in conjunction with price movements and other indicators. They do not always predict price movements accurately. |
|
High open interest means high liquidity |
While high open interest generally indicates liquidity, it doesn't guarantee it. Illiquid options can have high open interest due to large institutional positions. |
|
Open interest always increases before the expiry |
While open interest often increases as expiration approaches, it can decrease if traders close out positions before expiry. |
|
Open interest provides information about the option buyer's bias |
Open interest does not differentiate between option buyers and sellers. It reflects the total number of open positions, whether long or short. |
|
Options with high open interest are always more profitable |
High open interest options may have narrower bid-ask spreads, but they may not always be more profitable. Profitability depends on various factors, including market conditions and trading strategies. |
Moving forward, we will see the challenges that surround the open interest in options trading.
Challenges surrounding open interest in options trading
Below you can see the pitfalls and challenges to be aware of associated with the open interest in options trading.
- Over-reliance on open interest as a sole indicator: Open interest should be used in conjunction with other indicators for comprehensive analysis and decision-making.
- Misinterpretation of changes in open interest: Changes in open interest do not always signal price movements. They should be analysed alongside price action and other factors.
- Illiquid options with high open interest: High open interest doesn't always indicate high liquidity. Illiquid options can have artificially high open interest due to large institutional positions.
- Complexity of open interest data interpretation: Understanding the significance of open interest requires knowledge and experience in options trading analysis.
- Limited information on option holder intentions: Open interest does not differentiate between option buyers and sellers, making it challenging to gauge market sentiment accurately.
- Potential for false signals: High open interest levels can sometimes lead to false signals, especially when other market factors are not considered.
- Difficulty in predicting price movements: While open interest provides valuable insights, it does not guarantee accurate predictions of future price movements.
Let us also see how to overcome these challenges of using open interest further.
How to overcome the challenges of using open interest?
Below are the ways to overcome the challenges of using open interest.
- Use open interest alongside other indicators: Combine open interest analysis with price action, volume, technical analysis, and market sentiment indicators for more robust trading decisions.
- Verify open interest signals with price action: Confirm signals from open interest with actual price movements to validate potential trends or reversals.
- Evaluate liquidity beyond open interest: Assess bid-ask spreads, trading volume, and market depth in addition to open interest to determine options liquidity accurately.
- Continuous learning and experience development: Stay updated with options trading strategies and market dynamics to improve open interest analysis skills over time.
- Consider additional market sentiment indicators: Use options sentiment, put-call ratios, and other market sentiment indicators to complement open interest analysis.
- Develop a comprehensive trading plan: Integrate open interest analysis into a well-defined trading plan that considers risk management and trade execution strategies.
- Backtest trading strategies: Test trading strategies using historical data to evaluate their effectiveness and refine them based on past performance.
Conclusion
We've covered various aspects of open interest in options trading, including its definition, interpretation, significance, and practical applications. By learning how to analyse and interpret open interest data, traders can make more informed decisions and develop effective trading strategies.
Moreover, we've explored the relationship between open interest and price, demonstrating how changes in open interest can signal potential trend reversals or continuations. We've also discussed how Python can be used as a tool for analysing open interest data, providing traders with valuable insights and tools to enhance their decision-making process.
Additionally, we've addressed common misconceptions, pitfalls, and challenges associated with open interest, and provided strategies to overcome these challenges. By combining open interest analysis with other indicators and continuously learning and refining trading strategies, traders can improve their ability to navigate the complex world of options trading.
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File in the download
- Open interest in options trading - Python notebook
Author: Chainika Thakar (Originally written by Varun Divakar)
Note: The original post has been revamped on 13th June 2024 for recentness, and accuracy.
Disclaimer: All investments and trading in the stock market involve risk. Any decision to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.
