Think first in terms of options contracts: by owning an option, it signifies that there is interest in actually trading that stock, although at a different price. Since this represents your “interest” in owning it, the “open interest” is how many shares people may be interested in trading, even if they do not actually trade.
Open interest is not to be confused with volume; it is just the total number of options or futures that are owned and not yet expired. A second definition of Open interest is the amount of open interest before the market opens, i.e. the number of open buy orders before the market officially opens, since it shares the same idea (how many shares people are thinking about trading, even though those trades have not yet happened).
|1||Trader A buys 1 option and Trader B sells 1 option (for options and futures if there is a buyer there must always be a seller)||1||There is one option bought currently. The seller does not count in this case.|
|2||C buys 3, and D sells 3||4||A and C now own 4 options between them.|
|3||A sells 2, C sells 3, and D buys 5||2||A still has 1 sold (written), B has 1 sold, C owns 0, D has 2, if we look at the bought the open interest is 2 despite the volume being 5|
|4||C buys 5 and D sells 5||2||Since the options have just changed hands the open interest remains the same. The volume is 5 once again.|
|5||A sells 3, B buys 3, C buys 2, D sells 2||9||A now has 4 sold, B has 2, C owns 7 and D has 5 sold|
As you can see these transactions can get very complicated very quickly. The usefulness is undeniable, however, as it shows just how many people “interested” in the option.
Since open interest indicates the number of “open” bought options this can give an indication of market sentiment and therefore the strength of the current trend. If there is very little open interest but a lot of volume it may be a good time to check why so many people are selling off their options.
On the other hand, a sudden jump in open interest can indicate that a rise in volatility is likely but gives little information on the direction of trend.