The Importance of Open Interest
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Open interest provide useful information that should be considered when entering an option position. First, let's look at exactly what open interest represents. Unlike stock trading, in which there is a fixed number of shares to be traded, option trading can involve the creation of a new option contract when a trade is placed. Open interest will tell you the total number of option contracts that are currently open—in other words, contracts that have been traded but not yet liquidated by either an offsetting trade or an exercise or assignment.
For example, say we look at Microsoft and open interest tells us that there have been 81,700 options opened for the March 27.5 call option. You may be wondering if that number refers to options bought or sold. The answer is that you have no way to know for sure how many transactions have taken place but you do know that there are 81,700 options contracts that remain open. Since there is 1 bought position and 1 sold position for each of these contracts, there are 81,700 positions that remain bought to 'open' and 81,700 positions that remain sold to 'open' for the March 27.5 call option. There are always the same number of positions on either side of the open transactions.
So, 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 accordingly. If both parties are opening positions then the open interest goes up accordingly.
One way to use open interest is to look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, this suggests that trading in that option was exceptionally high that day. Open interest can help you determine whether there is unusually high or low volume for any particular option.
Open interest also gives you key information regarding the liquidity of an option. If there is no open interest for an option, there is no secondary market for that option. When options have large open interest, it means they have a large number of buyers and sellers, and an active secondary market will increase the odds of getting option orders filled at good prices. So, all other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable spread between the bid and ask.
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