Why Open Interest is Recorded
When a company becomes listed on a stock exchange they issue a fixed number of shares for sale. Although they can subsequently issue more shares or buy back a number of issued shares and then remove them from the market at any given time, there is a fixed amount of shares in existence.
The same isn't true for options contracts though. There's no minimum or maximum number of contracts that can be written for any particular underlying asset, there will essentially be as many contracts in existence as there needs to be to satisfy the demand in the marketplace.
The actual number of options contracts needs to be tracked so that there is a formal record of how many of them exist at any time, and this is where open interest comes in.
How Open Interest Works
When you buy or sell stocks you are trading them with another party and the number of stocks in existence doesn't change. They are simply transferred from one party to the other.
However, with options contracts, the same ttheory doesn't necessarily apply.
There are two different orders you can place when buying options: buy to open and buy to close. There are also two different orders you can place when selling them: sell to open and sell to close.
When you open a new position by placing a buy to open order you aren't necessarily buying contracts that already exist from a party that owns them, you could be buying new contracts that are being written by the seller.
Because of this, when you open a new position the number of contracts in existence could increase which means the open interest of them will go up. If you subsequently close that position by using the sell to close order, they could be sold back to the writer and therefore cease to exist.
Options Open Interest as an Indicator by ChartGuys.com
This would cause the open interest to go down.
When you place a sell to open order, you are writing new options contracts to be sold so the open interest would go up. If you later chose to place a buy to close order on those same contracts, you would be closing your position by buying them back and it would go down.
As you can see, the number of options contracts in existence can vary depending on what trades are being made but, in any given day the open interest of an options contract can fluctuate quite dramatically.
Keeping Tabs on Open Interest
It's calculated at the end of each day rather than in real time, so whenever you see it quoted it would be accurate up until the end of the previous trading day.
Using Open Interest in Options Trading
A number of options traders make the mistake of ignoring open interest, assuming that it isn’t really that relevant.
Conversely, a number of traders over value the importance of it, believing it's the sole indicator of the liquidity of the contract.
The truth is actually somewhere in the middle. It's certainly relevant, but it's only one of three indicators of liquidity.
The liquidity of options contracts is very important to traders.
Liquidity gives you an idea of how easily specific options can be bought and sold at the market price. Highly liquid ones are generally easy to buy and sell, and orders will be filled quickly.
Ones with low liquidity, on the other hand, aren't necessarily that easy to trade. Ideally, you want to be trading ones with a high liquidity to ensure that you can enter and exit positions with relative ease.
Options contracts that have a high open interest tend to also have high liquidity, but as mentioned above, there are other factors to consider too.
Those other factors are the trading volume of an option and its bid ask spread.
High trading volume of an option generally indicates high liquidity. Ab small bid does as well. Only by looking at all the relevant criteria is it possible to get a reasonably accurate idea of how to determine how liquid an options contract is.