What is Open Interest?
Open interest is a term associated with derivatives trading markets such as futures and options. Open interest indicates the amount of active contracts at a given time. It is important to note that futures contracts are derivatives where two parties decide to sell or purchase an underlying asset at a predetermined price on a specified future date.
In this instance, open interest refers to the total number of active contracts that are traded within a specified time bracket.
Investors can use open interest as a metric to measure the market sentiment and access the upcoming futures price tangent. The main idea regarding this concept is that it reveals more information regarding the general activity of markets as well as probable future moves.
When the open interest metric is falling, it may point towards a deteriorating price trend. On the other hand, an inclining open interest shows rising market interest and potential of long-term price appreciation.
The Implications of Open Market on Market Direction
Investors can understand market direction by analyzing the open interest. At the same time, traders can collect useful information regarding future price movements for both bullish and bearish trends.
In this way, open interest with price point appreciation is a strong trend and indicative of an upcoming rising momentum. This means that bulls are dominant and the price of the underlying asset is expected to increase.
Such a scenario also improves general market sentiment and shows a greater consensus among all market participants. In contrast, a bearish movement takes place when open interest continues to increase despite price decline.
Such a situation stipulates downward value depreciation. At the same time, such an alignment also confirms increasing selling pressure and agreement among investors moving to the negative territory. Open interest is useful to identify trend reversals.
Trading Volume Vs Open Interest
Trading volume and open interest are two important trading market metrics that help investors. Here are some similarities and differences between the two analytical methods:
Definition
Trading volume is one of the most popular metrics that is used to understand the price momentum of a given asset. Trading volume is the total number of active market participants or investment activity taking place within a defined time bracket. It means that trading volume is the difference of total purchases and total sales of a given asset class within a defined time duration.
However, open interest measures the total number of outstanding contracts that have not been redeemed by investors after the deadline. In this manner, the open interest for a derivative contract represents the obligation of investors for an underlying asset.
Application
Trading volume is applied to both spot prices and derivative contract trading to measure the total number of purchases and sales for a specified asset. On the other hand, open interest is a metric that is only applicable to derivative contracts namely futures and options for an underlying asset.
Duration
Trading volume is concerned with the immediate market activity whereas open interest is based on an on-going commitment such that it encompasses the upcoming date for the derivatives contract completion.
Coverage
Trading volume is often used by traders to make sense of short-term price movement. On the other side, open interest is most popular among investors who have a long-term perspective.
Scale
Trading volume deals with the total quantity of trades for a given duration. Meanwhile, open interest is concerned with the total number of derivatives contracts.
Liquidity
For spot market analysis, the trading volume metric does not account for new or existing reserves. But for derivative contracts analysis, it takes the available liquidity and market immediacy into account. However, open interest considers contracts that are not closed after delivery or offset with a counter deal.
Stability
Trading volume is most effective to quantify intraday trading statistics whereas open interest makes sense of market participant commitments.
Conclusion
Open interest is one of the best metrics to identify trend divergence, trend reversal, and determine future market direction. However, it has some limitations such as unaccounted disclosure, price volatility, and underrepresentation of institutional positions.
