Open interest provides useful information that should be considered when evaluating an option position. When trading stock, there is a fixed number of shares to be traded, or shares outstanding. However, when trading an option contract, you may be opening a brand-new position or closing an existing one. That’s why whenever you enter an option order, it’s not good enough to simply say "buy" or "sell" as you do with a stock. You must also specify whether you are buying or selling "to open" or "to close" your position. For each buyer of an options contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered 'open'. Open interest is the total number of option contracts that are currently open, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment. While there may be as many open option contracts as trader or market demand warrants, options do have position limits as established by exchanges and regulators to manage marketability and eventual contract closure following expiration dates. A common mistake among new traders to options is to consider open interest as the same as the number of option contracts traded. Both a "sell to open" and "buy to open" position can but will not necessarily increase open interest. Similarly, "sell to close" and "buy to close" can but will not necessarily decrease open interest. When an option is traded with one party opening and one party closing, the open interest remains unchanged. If both parties in the transaction are closing positions then the open interest decreases. If both parties are opening positions, then the open interest goes up. There is no way to exactly determine how many "sell" and "buy" positions or trades are executed, only the net total open interest amount. Like volatility, it has no directional component, it is just an end of day tally of unsettled contracts.
When is the open interest calculated?
Open interest is calculated centrally on an end-of-day basis by the Options Clearing Corp (OCC) for US options. The next morning, Open interest is displayed on the OCC web site but it is not distributed industry-wide until the next business day morning. The impact of this difference is felt over the weekend when the OCC web site is showing Friday's open interest but other financial sites are showing Thursday's open interest. For the rest of the next trading day, the open interest figures remain static. Open interest can vary from the call side to the put side, and from strike price to strike price.
Open interest is an especially important metric for market makers and professional traders. It provides insight in helping to choose which option strikes to trade, for example in executing dividend capture strategies. A large cluster of open interest around strikes can be interpreted as a possible trading opportunity and can signal a stock price pin at expiration. If a break in stock prices occurs through a large open interest at a particular strike, the move can be magnified by forcing hedges and stopping losses on option positions as the stock breaks through the strike prices. High Open Interest can also be viewed as an indicator supporting current market moves or committed positions that are investment bets on future stock outcomes. Additionally, traders may further parse high open interest to specific expiration, strike and option type to assess what the order flow is actually targeting, and track the performance and implied volatility of that specific option. By analyzing the changes in the open interest figures at the end of each trading day, some conclusions about the day’s activity can also be drawn. Increasing open interest is an indication that new investment is flowing into the market. The result will be that the present market momentum (up, down or sideways) is likely to continue. Declining open interest indicates the market is closing positions (liquidating) and implies that the current price trend may be coming to an end. Knowledge of open interest can also be useful toward the end of major market moves. A leveling of open interest following a sustained price advance is often an early warning sign of an end to an upward movement in the market. However, neither an increase in volatility nor open interest necessarily indicate anything about the direction of future price movements.
How to use the opening filter to find potential opening position orders?
The opening filter is designed to exclude flow orders that exceed both the open interest of the contract and more than half of the day's trading volume. For instance, if an order is executed on the ask side with a size of 1000, and the open interest for that contract is 100, it can be inferred that this flow order represents an opening position. This is because the dealer must initiate new positions to fulfill the trader's request to buy. By enabling the OPENING filter, the flow display will only show option orders associated with opening positions. This filter effectively removes orders that have a size surpassing the combined value of the open interest for that particular option and the remaining volume for the day.
How is the opening tag calculated and what does it mean?
The opening position tag becomes visible when the order size exceeds both the cumulative volume from the previous day and the total open interest. This is the only reliable method to determine whether a position is indeed opening. In mathematical terms, it can be expressed as: (Size of Trade) > (Preceding Volume + Open Interest) = New Position.
A quick disclaimer is in order here: there is no absolute certainty that these contracts were initiated to establish long positions. Such a conclusion is speculative and based on contextual information. It's equally plausible that they were sold short. The only certain fact is that this position is newly established.
What is the difference between the ASK SIDE and BID SIDE in terms of an opening order?
While both orders shown above are opening orders, there is a distinction in their trading dynamics. An opening order executed on the ASK SIDE is more likely to be sold by the Market Maker and bought by the trader. Conversely, an opening order executed on the BID SIDE is more likely to be bought by the trader and sold by the Market Maker.
How to verify the opening position
We can verify the opening position by option chain data from the next date. Take the screenshot below as an example, On 06/08/2023, We can see that there is a PUT option order for SOFI with a size of 44, and the Open Interest is 1(which reflects the unclosed contract before the market opening), the size of the order is greater than the Open Interest, which indicates this order is an opening position at the time this order placed, by loading the latest real-time Option Chain Data on 06/09/2023, we can see that latest option chain data for that contract is 45, which is exactly equals to the size of yesterday's open interest plus the size of the flow order, so we can verify that this order is an opening position.
On Oct 27th,2022, Amazon shares plunged more than 20% after hours. If we search the options flow with the opening filter on, we can identify that traders placed orders on puts from Oct 20th to Oct 25, and these option contracts has 0 open interests, so those orders are all open to buy, which is very aggressive sentiment, so we can tell that this trader had solid confidence and placed a huge bet on that the AMZN will plunge after earning report for Q3.
Why does determine Opening Position so important
In short, we need to identify opening position orders from those orders that are used for hedging. It's important to recognize that a significant portion of the stock market today is controlled by large institutions. These institutions typically adopt a long-term approach, gradually building their stock positions over several months with the intention of holding them for an extended period.
When these institutions sense potential volatility on the horizon, such as an upcoming earnings report or significant news event, they often choose to safeguard against potential downsides by purchasing options. It's crucial to understand that unusual options activity frequently stems from institutional hedging strategies rather than individuals expressing a specific directional view.
The primary reason behind this hedging behavior is that institutions generally aim to retain their existing shares. They hold a long-term perspective on the stock and short-term volatility does not alter their overall outlook. However, since they manage client funds, institutions are cautious about preventing clients from becoming alarmed and withdrawing their investments due to a small loss resulting from a substantial move in a single stock during a particular quarter.
Moreover, institutions face challenges when attempting to sell their positions quickly, as doing so could heavily impact the market and may have tax implications to consider. Considering these factors, institutions find it more advantageous to employ options to mitigate their short-term exposure to a stock rather than resorting to outright share sales.
By utilizing options, institutions can effectively manage risk, protect their long-term holdings, and provide stability to their clients, while avoiding potential market disruptions caused by sudden selling pressure.
How to analyze option interest liquidation by IV
Long Liquidation happens when there is a decrease in open interest along with a decrease in implied volatility, indicating that traders are trying to sell out of their long positions in the option.
Long Buildup is an increase in open interest along with an increase in implied volatility, indicating that traders are adding to long positions in the option.
Short Buildup is an increase in open interest but a decrease in implied volatility, suggesting that traders are selling more contracts on short positions in the option.
Short Covering is a decrease in open interest but an increase in implied volatility, suggesting that traders are buying back to cover short positions in the option.