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How Do You Calculate Open Interest

Filed Under Beginner Options Trading 

Open Interest
In the first chapter, we mentioned that the column labeled “Open Int” in Table 1-1, which has been reprinted below as Table 4-1, represented open interest. Now it’s time to take a closer look at what those numbers represent.
 
Table 4-1: EBAY Option Quotes
 

EBAY Options Quotes

Because of the way options are traded, the OCC (Options Clearing Corporation) must account for the total number of outstanding contracts. This is because options are created out of thin air when two traders enter into opposite sides of the agreement. There is not a fixed number of option contracts like there is for shares of stock. Because there is a fixed number of shares of stock, you only need to use the words “buy” or “sell” when you trade shares of stock. However, when you trade an option, the OCC needs to know if you are entering into the contract or getting out of it. So if you are buying a call option to enter (or increase) the position, you need to enter the order as “buy to open.” When it comes time to exit (or reduce) that position, you would enter an order to “sell to close.”
We can also enter into an option contract by selling it first. If you sell a call option to enter (or increase) the position, you would enter the order as “sell to open.” When closing (or reducing) the position, the words “buy to close” would be used.
 
This can be a little confusing to new traders but it is actually quite simple. Just remember the key words “entering the contract” or “exiting the contract.” If you are entering, you are “opening” the contract. If you are exiting the contract, you are “closing.” When you enter an option order online, the computer will prompt you to either “buy” or “sell” and another section will ask you to specify “to open” or “to close.” You will need to check off one from each section.
 
Let’s take a look at a few examples. Let’s say you currently have no Intel options in your account and you buy 5 Intel $30 calls. You would enter the order as “buy to open.” Now assume that, at a later date, you wish to buy two more contracts. This is still an opening transaction since you are increasing the size of the position. You have simply “opened” or entered into two additional agreements. At this point, you would be long 7 Intel $30 calls. Now let’s say you decide to sell 4 contracts. Because you are reducing the size, this would be entered as “sell to close.” At a later time, if you sell the remaining 3 contracts, it would also be a “closing” trade since you are exiting or eliminating the position. It’s important to understand that “buying” does not necessarily mean you are entering the position. The reason is that you could enter an option position by selling it first. For example, if you sell a call to open, you are accepting money in exchange for the potential obligation to sell shares of stock. This is a common strategy called the “covered call” and one we’ll look at in depth in Chapter Seven. The point is that you can enter into an option agreement by either buying it or selling it. It just depends on whether you want to pay money for the right to buy or sell or receive money for the obligation to buy or sell.
 
The “open interest” column in Table 4-1 keeps track of how many open contracts there are for that particular option. To do so, one could either tally all long positions or all short positions to get the total number of outstanding contracts. This is because each contract has a buyer and a seller (a long and a short position). Some people mistakenly believe that the open interest is the total number of long and short positions. However, this would double count the actual number of open contracts.
 
For example, let’s say today is the first day a particular call option starts trading so that the open interest is zero. You wish to buy 10 calls and another trader wishes to sell 10 calls. You would enter the order as “buy to open” while the other trader would enter an order to “sell to open.” 
 
The total open interest is now 10 contracts. Note that we can get this answer by either counting all 10 long positions or all 10 short positions. But if we count all long and short positions then we get a total of 20, which exactly doubles the correct answer. The reason 20 is not correct is because each contract requires two people. Think of it like buying a house. If you buy a house then someone else must sell that house to you. You have two “traders” but only one house has been sold. For the same reason, if you buy 10 contracts and another trader sells 10 contracts then only 10 contracts changed hands and not 20.
 
Whenever both traders are entering “opening” transactions then open interest will increase. This is because both traders are “entering the positions” so open interest must be increasing.
 
Now let’s assume that you wish to sell five of your contracts. You would enter an order to “sell to close.” The trader on the other side must be buying since a buyer is required to complete your sales transaction. But depending on whether he’s opening or closing will determine what happens to open interest. For example, if the trader is buying to close, then open interest will decrease by five since both of you are closing positions. However, if the other trader is buying to open, then one trader is opening while the other is closing and open interest remains unchanged.
 
Table 4-2 will help to summarize what happens to open interest based on the actions of both traders:
Table 4-2
 
Trader #2
Trader #1
Opens
Closes
Opens
Increases
Unchanged
Closes
Unchanged
Decreases
 
 
Another way to interpret the chart is that if both traders are opening, then open interest will increase. If both are closing then open interest will decrease. And if one is opening and the other closing then open interest remains unchanged.
 
Let’s now go back to Table 4-1 and interpret the open interest numbers. The first call option listed is the July $32.50, which shows an open interest of 7,319. This means that there are 7,319 open contracts for this month and strike existing at this time. Because each contract represents 100 shares of stock, we know there are really 7,319 * 100 = 731,900 shares of stock being controlled by this one contract.
 
We see from Table 4-1 that the volume for this contract today (so far) is five. Assuming this is the total volume by the close of trading, what will be the new open interest tomorrow? Many new traders believe that the open interest must be 7,319 + 5 = 7,324. However, from what we previously learned, we know that is not necessarily true. This is because we have no idea whether the five contracts were “opening” transactions or “closing” transactions. If one trader bought five contracts “to open” and the other sold five contracts “to open,” then open interest will, in fact, increase to 7,324 tomorrow. But if one trader bought five contracts “to close” and the other sold five contracts “to close,” then open interest will decrease to 7,319 – 5 = 7,314. And if one trader bought “to open” and the other sold “to close,” then open interest will remain at 7,319 tomorrow (it would also remain unchanged if one trader bought “to close” and the other sold “to open”).
 
Open interest tends to be highest for the at-the-money contracts. In Table 4-1, we would probably consider the $37.50 calls the at-the-money but, in this case, they do not have the highest open interest. Part of the reason is that traders were very bullish on eBay at this time and were buying the higher strike $40 call. For the puts, the highest open interest doesn’t match with the $37.50 contracts either. Instead, the highest open interest contracts are the $35 and $32.50 puts. This is often typical for puts if they are used for insurance. Remember, most traders were bullish on eBay at this time, so relatively few were buying at-the-money puts as a bearish bet. However, when traders and investors use puts for insurance reasons, they typically buy out-of-the-money contracts because they are cheaper and still protect a significant part of their holdings. But generally speaking, you will find the highest volume and open interest for the at-the-money contracts.
 
Here’s an interesting question: Why do you suppose that the open interest is zero for all of the August calls and puts? The reason is that the last trading day for the June options was June 17 (third Friday of that month). From our lesson on expiration cycles, you know that once the June contracts expire we must have July and August contracts traded (current month plus following month). This means that August must not have been trading and they were rolled out on the same date that these option quotes were taken (July 20). In other words, July 20 is the first trading day for the August options and that’s why their open interest is zero.
To be continued……

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