Concept of Open Interest in options trading:  Meaning, Uses and Examples

Open interest (abbreviation: oi) is a core concept used while trading derivatives. It shows market sentiment of the underlying stock or index and helps with potential price moves. Simply put, open interest data shows the total number of outstanding derivative contracts (futures and options) that have been initiated, but not been settled or closed in the market. 

Oi data specifically shows active positions made by traders, unlike the volume which shows total contracts traded at any specific time. This makes open interest a very powerful indicator in assessing market liquidity, strength, and direction. This guide explores the meaning of open interest, different market scenarios it helps identify, and practical examples to help traders leverage this information effectively.

Understanding Open Interest

Open interest refers to the total number of derivative contracts (futures and options) that remain open or active in the market at a given time. These are positions that traders have opened but not yet closed. The positions will be considered to be closed – if the trader makes a position opposite to its original position (bought PUTS and later sold the same strike and expiry PUTS ) or when the contract expires.  When traders open new positions, open interest increases; when they close existing positions, open interest decreases. Remember that, it doesn’t matter if a trader bought or sold the contracts, both of these activities will lead to rise in open interest. 

It is important that you understand the concept of open interest because it will help you to distinguish between new money entering the market versus existing positions changing hands. When oi increases, it indicates new capital flowing into the market. When new money enters, conviction towards the ongoing trend is stronger, as more people feel that the market should continue its current direction. Conversely, when open interest decreases, it signals money leaving the market, which might indicate loss of interest or confidence. 

Difference Between Open Interest and Volume

As a novice trader, you might get confused between open interest and trading volume. Remember, they measure different aspects of market activity:

• Volume counts the total number of contracts traded during a specific period (usually a trading day). Each buy and sell transaction contributes to the volume.
• Open interest tracks only the number of contracts that remain active in the market. It doesn’t increase when existing contracts change hands.

For example, if trader A who holds 1 futures contract sells it to trader B, the volume increases by 1 contract, but open interest remains unchanged because no new contract was created—ownership simply transferred between parties.

Moving forward, lets understand call and put options, which are an important part of options open interest analysis.

CE and PE in Open Interest Context

While studying the derivatives markets, traders often tackle the terms CE and PE, so understanding this basic terminologies is important.

• CE (Call European): Refers to European-style call options. A call option gives the buyer the right (but not obligation) to buy the underlying asset at a specified price.
• PE (Put European): Refers to European-style put options. Put option gives the buyer the right (but not obligation) to sell the underlying asset at a specified price.

Open interest for CE and PE options makes it easy for traders to understand w

hich side the market may be heading towards. Higher oi in CE options might indicate bullish sentiment, while more PE side oi might suggest bearish sentiment in the market. 

4 Key Market Scenarios with Open Interest

If you are able to identify the relationship between price moves and change in open interest, you will be able to pinpoint important market scenarios. Below are 4 concepts that help in identifying bias in the share market used while reading the option chain. 

#1 Long Build-Up

When price and open interest rise together, it is known as Long build-up. This situation indicates that new buyers are entering the market with expectations of bullish move, which in turn pushes the price higher. 

It’s generally considered a strong bullish signal.For example, if Reliance shares move from ₹2,500 to ₹2,550 while open interest in Reliance futures increases from 10,000 to 12,000 contracts, it suggests traders are actively building long positions with the expectation of further price appreciation.

#2 Short Build-Up

Short build-up occurs when the price of the underlying asset decreases but the open interest increases. Easier and more logical way to understand this is – If price is falling, but oi is rising, this means more and more traders are expecting bearish moves to continue and that is why making new short positions. This is why short buildup is considered to be a bearish signal.

Lets understand this with an example – if HDFC Bank shares fall from ₹1,800 to ₹1,750 while open interest rises from 8,000 to 9,500 contracts, it means traders are actively creating new short positions, in anticipation of further decline. 

#3 Long Unwinding

Long unwinding is observed when both price and open interest decrease together. This scenario suggests that existing buyers are exiting their long positions by selling, leading to price decline. It signals weakening bullish sentiment and might indicate a potential downtrend. 

For example, if TCS shares drop from ₹3,800 to ₹3,700 while open interest decreases from 15,000 to 13,500 contracts, it suggests long position holders are closing their positions, potentially due to loss of confidence in further upside.

#4 Short Covering

Short covering happens when price increases while open interest decreases. This pattern indicates that existing short sellers are buying back shares to close their positions, pushing prices higher. It might signal the end of a downtrend or a temporary pullback in a larger downtrend.

For instance, if SBI shares rise from ₹650 to ₹680 while open interest falls from 20,000 to 18,000 contracts, it suggests short sellers are closing their positions, possibly due to fear of further price increases or to lock in profits.

Practical Examples to Understand Open Interest

Let’s walk through a multi-day example to see how open interest changes with different market transactions. This will make it clear that oi is not only used intraday but also positionally.

Monday:

• Arjun buys 6 futures contracts
• Varun buys 4 futures contracts
• Neha sells 10 contracts (to both Arjun and Varun)
• Result: 10 long positions (6+4) and 10 short positions = Open Interest is 10

Tuesday:

• Neha transfers 8 of her short contracts to John (selling to him)
• This is merely a transfer of existing contracts
• Result: Open Interest remains 10 (no new contracts created)

Wednesday:

• John adds 7 more short positions
• Arjun buys 3 more contracts (from John)
• Varun buys 2 more contracts (from John)
• Neha closes her remaining 2 short positions by going long
• Result: 15 long positions and 15 short positions = Open Interest increases to 15

This example illustrates a key principle: open interest only changes when new contracts are created or existing ones are closed, not when contracts change hands between traders. Similarly tracking Nifty open interest positionally or even intraday will help you to understand where money in flowing.

How Traders Use OI for Stock Analysis

Open interest serves as a valuable tool for traders in several ways:

Market Strength and Confidence

Increasing open interest along with price trend (up or down) generally confirms the strength of that trend. It shows that new money is flowing into the market, supporting the current direction. Inversely, if open interest is falling, while the price continues to stay in a direction (upside or downside) may hint at a weakening trend. 

Reversal identification

A sharp decline in open interest after an extended trend might signal an upcoming reversal. This happens as traders are closing their existing long positions which set’s off the open interest and no new oi is being added. 

Liquidity Assessment

Traders dealing with large quantities (order blocks) might often face liquidity issues especially in stock options. At such times, choosing strike with higher open interest offers better entry and exit scenarios as they are liquid. 

Sentiment Analysis

Comparing call options versus put options (put-call ratio) helps with identification of market sentiment. Higher put-call open interest ratio might indicate bearish sentiment, while a lower ratio suggests bullish expectations.

Before you go, 

Open interest is a powerful indicator that provides valuable insights beyond simple price and volume analysis. By tracking the number of outstanding contracts in the derivatives market, traders can better understand market liquidity, strength of trends, and overall participation. When combined with price movement analysis, open interest helps identify specific market scenarios like long build-up, short build-up, long unwinding, and short covering.