Open Interest (OI) is the number of contracts outstanding in the marketplace. Open Interest only applies to futures and option contracts. Changes in open interest either confirms price action or acts as a warning of a potentially weakening trend.
A hypothetical situation is given next to help grasp the concept of Open Interest:
- A new futures contract expiration month is opened for trading. Currently, no one has bought or sold a futures contract.
- A trader (Trader #1) buys a futures contract, but in order for this to happen, someone has to sell that trader the future. Therefore, for every buyer there is an equal and opposite seller (Trader #2). When this transaction occurs, the open interest is increased from zero to one. There is now one contract outstanding in the marketplace.
- Trader #3 decides to sell a future and subsequently another trader (Trader #4) has to buy that futures contract; therefore, open interest is now at two.
- Trader #1 goes to the marketplace and sells his/her futures contract. Trader #3 decides to buy back his/her short future. After the transaction takes place, Trader #1 no longer owns a futures contract. Similarly, Trader #3 no longer owns a futures contract. Effectively, the marketplace has one less futures contract outstanding. The open interest went down to one.
Generally open interest increases over the life of the futures contract (note: futures contracts expire, same with options). When futures contract months or quarters transition from one month or quarter to the next month or quarter, the future closest to expiration (called the "front month") decreases in open interest and the next futures contract (called the "back month") increases. This is shown with the chart of the E-mini S&P 500 Futures contract above.
The chart above of the E-mini S&P 500 Futures contract shows both the March S&P 500 future and the June S&P 500 future as the futures near March expiration. Note how the March and June futures contract open interest rises steadily over time; this is normal over the life of a futures contract.
Also note the dramatic decrease in the open interest of the March S&P future as the contract is nearing expiration. In contrast, note the dramatic increase of the June S&P futures contract as futures traders "roll over" their futures positions to the next futures expiration contract (June).
Learning about Open Interest is important, but using it to help futures or options trading is better. Interpreting Open Interest is up next.
