How to Use Open Interest to Predict Market Moves

Open interest is an important tool in options trading. It represents the total number of outstanding contracts that haven’t been exercised, gone to assignment, or expired as worthless. Traders can leverage open interest numbers to gauge market sentiment, confirm market trends, and discover the level of liquidity the market is currently experiencing. Perhaps most importantly, traders can use open interest to predict potential price movements.

This guide is designed to help traders understand how to use open interest effectively. Keep reading to learn ways of using open interest to predict market moves—you’ll up your trading game extraordinarily once you have a good idea of what open interest indicates.

What Is Open Interest?

Open interest refers to the total number of outstanding contracts that haven’t been closed out or settled. They ultimately represent the number of positions held by market participants, those that haven’t gone to assignment, have been exercised, or expired as worthless. Open interest increases each time a new contract is opened, and it decreases when the contract is closed out.

Open interest is a strong indicator of a liquid market, one where traders can enter or exit positions easily and quickly. Another significant use of open interest in trading options is using it to gauge shifts in market sentiment. When open interest goes up, it could be a sign that new money is entering the market and that the current trend is likely to continue.

How Open Interest Is Different From Volume

While open interest refers to the total number of outstanding contracts that have been opened but not closed out or settled, volume is the measure of the total number of contracts traded during a certain period. In the next section, we’ll dive into some more interesting details on how open interest and volume are two very different, yet complimentary, technical indicators.

Check out this simple example that we feel illustrates the concept of using open interest and volume in conjunction with one another fairly well:

The market has 100 contracts being traded. There are only 50 that stay open, which means that the volume is 100 and the open interest is 50.

Open Interest vs. Trading Volume

Trading volume is a measure of the total number of contracts traded within a certain period of time, while open interest tracks the number of outstanding contracts that haven’t been settled or closed. Volume reflects daily trading activity, while open interest reflects market participation and unsettled positions.

There are several other key differences between open interest and trading volume, including the following:

Open Interest

• Open interest can indicate the strength of a trend or the level of market participation
• Open interest represents the number of outstanding contracts (those that have been opened but not closed or settled)
• Open interest increases with the increase of new contracts opened, and it decreases when current contracts are closed out
• Low open interest paired with high volume can indicate the end of a current trend, and high open interest paired with low volume can indicate the strength of a current trend

Trading Volume

• Provides insights on the buying and selling activity levels in the market
• Trading volume increased with every trader, including when opening a new position or closing a current position
• The number of contracts traded during a specific period
• Higher trading volume indicates a bigger number of buyers and sellers as well as strong liquidity

Despite their differences, open interest and trading volume should be analyzed together for better market insights. This is a great rule of thumb for traders using any kind of technical indicators. While you don’t want to swamp yourself down having too many working together at the same time, it’s highly recommended to use three or four together for crosschecking purposes to get the best read on the market.

Using Open Interest and Volume

This chart essentially outlines how to use volume and open interest to decipher what’s going on with the current market conditions. It’s key to combine the element of the stock’s price as well as a complete picture of what trends might lie in store.

Why Open Interest Matters in Options Trading

Being one of the prominent technical indicators (along with volume), open interest plays a significant role in options trading where investors can get a good gauge of market liquidity and market sentiment as well as get confirmation of the current market trends to find out if they are short-term or long-term. We’ll explain more about the benefits of using open interest as a technical indicator in short order.

• Liquidity Indicator: Higher open interest means better liquidity, reducing bid-ask spreads. It means there are more active participants and contracts available for trading. The narrower bid-ask spreads are ideal for traders looking for options where they can enter or exit the positions for a fair price that works for their trading goals.
• Market Sentiment Gauge: Increasing or decreasing OI can signal bullish or bearish sentiment. Rising open interest with rising prices could signal new money entering the market (a strong bullish trend), rising open interest with falling prices could signal the continuation of a bearish trend, and declining open interest with rising prices could be a sign that a trend is losing its momentum, and declining open interest with falling prices could be signaling that a trend is weakening.
• Confirmation of Trends: By using volume in conjunction with open interest, traders can use this combination as an indicator to confirm both continuing trends or possible trend reversals.

How to Analyze Open Interest to Predict Market Moves

To effectively predict market moves, traders need to analyze open interest and its relationship to a host of other factors like rising or falling prices, the put-call ratio, and potential price spikes. We’ve outlined a lot of these concepts below to give you an even deeper understanding of how open interest can be used when joined with other trading elements.

Open Interest and Price Relationship

For a visual example of the relationship between open interest and price, see the comparison chart two sections back that also include volume into the equation. As far as open interest and price go, these are the combinations that signal bearish or bullish sentiment as well as weakening trends, potential reversals, or current trends.

– Increasing Open Interest + Rising Price → Bullish Signal
– Increasing Open Interest + Falling Price → Bearish Signal
– Decreasing Open Interest + Rising Price → Weakening Trend
– Decreasing Open Interest + Falling Price → Potential Reversal

Using the Put/Call Ratio with Open Interest

The call-put ratio is a metric that compares the trading volume of put-to-call options. The period that it focuses on is a single trading day and it’s calculated by dividing the number of put options by the number of call options over a single day of trade. It’s a way of gauging the overall market sentiment at the moment:

• If the put-call ratio is high, this indicates bearish sentiment. What’s happening is that more traders are buying puts with the expectation that the market is on the decline.
• Low PCR is the exact opposite. It’s signaling bullish sentiment and as a result, traders are buying more calls as they’re expectant that the market is going to rise.

To better understand the put-call ratio, it’s best to show you the key thresholds:

• PCR > 1 → Bearish sentiment
• PCR < 1 → Bullish sentiment

Combining PCR with open interest gives a more complete picture of the market as a whole. Analyzing the trends of both the put-call ratio and open interest can help traders understand the direction the market might be going as well as the strength of the market sentiment that’s backing the theory of the direction. Using this technical indicator combination also helps with confirming signals and taking up a contrarian approach to trading. Traders can confirm potential trend reversals or turning points, in addition to using extreme levels of PCR as possible signals of a reversal of the current trend.

Open Interest Build-Up Near Strike Prices

This occurrence can indicate potential support or resistance levels in the underlying asset. Taking a look at open interest near-strike prices can reflect the collective expectations of options traders regarding future price movements. High open interest at a certain strike price can suggest that traders are anticipating the underlying asset’s price to find either support or resistance at that level.

Traders with experience and a keen eye will use the open interest build-up to establish which strike prices the underlying asset is likely not to cross. They believe that the market is unlikely to rise above a resistance level or to fall below a support level. This is a good way of establishing the possible boundaries of future price movements.

Max Pain Theory

This theory for options trading suggests that the underlying asset price tends to gravitate toward a specific strike price, which many refer to as the “max pain” price. It’s this price that the greatest number of options contracts would expire as worthless and, therefore, cause the most financial pain to the options trader.

The Max Pain Theory states that options that are heading toward expiry have the price of the underlying stock gravitating toward the price at which the maximum number of options contracts will expire as worthless. Market makers and other big traders might choose to change the asset’s price to reach the “max pain” point to profit as much as possible when the options expire as worthless, and they can keep the money paid for the options.

Unusual Open Interest Spikes

When there are several spikes in open interest, it usually indicates strong market activity and investor interest. These spikes happen when there’s a sudden or significant increase in the number of open contracts for a specific option. In addition to indicating investor interest or strong activity, these spikes could signal the catalyst for a stock’s price movement.

How to spot unusual surges in OI that may indicate insider positioning or smart money moves can give you a leg up in options trading. To detect these open interest surges, traders must look for large, concentrated trades with a combination of OI increases and high volume. Traders want to specifically look for options with short expirations that are out-of-the-money. Finding these surges is the trader’s ticket to finding smart money moves or insider positions that they could emulate to prepare for market changes.

Tools to track these movements include the following:

• Option Chain Analysis: Look at options chains to get all the relevant information needed on the positions you’re looking to invest in, including the specific underlying asset, strike prices, expiration date, and the trading opportunities (call or put options).
• Open Interest Heatmaps: This refers to a visual representation of the distribution of open interest across different strike prices and expiration dates within an options chain. Heatmaps let traders quickly identify the high and low activity areas and the potential support or resistance levels.

Case Studies: Open Interest in Action

Let’s look at a couple of case studies that showcase open interest as a technical indicator in action. In these examples, we will outline how open interest levels were helpful for traders who were looking to predict major market moves and come out stronger on the other side. The real-world examples we’ll examine are the Tesla (TSLA) stocks in 2023 where open interest surges predicted a breakout and the S&P 500 in 2022 open interest clusters indicated a downturn.

Tesla (TSLA) — Open Interest Surge Before a Breakout

Background

In 2023, Tesla experienced a surge in business for vehicle deliveries. Their profits reached 1.8 million along with a 15% revenue increase to $82.5 billion. In addition, the company saw 35% growth in Tesla Energy sales. By the halfway point of the year, Tesla was trading in a consolidation range between $240 and $260. This gave traders and investors uncertainty on whether the stock would reach new highs or face resistance and pull back.

Open Interest Analysis

Looking at open interest in this scenario, traders saw a considerable increase in open interest on the $270 and $280 strike call options over several trading sessions. This was evident mostly with contracts that had an expiration date that was two weeks out. Another notable consideration was the strike prices’ daily volume being lower than the increase in open interest. What this was signaling to investors was that new positions were being created. It wasn’t the result of traders closing out their contracts.

In addition to the open interest increase and the influx of new money into the market, the Put/Call Ratio (PCR) dropped significantly, which was a signal that most traders were betting on an upward move. On the other side of things, the put option’s open interest did not see the significant rise that call options did. This was a sign that traders were holding bullish sentiment about the Tesla stock and seeing the growth trend continuing.

Price Reaction

Fast forward to not even a week later and Tesla’s stock climbed out of the consolidation range and went all the way to $275. This was powered by the new money flushed into the market along with the strong buying volume. This was great news for the traders or investors who initially saw the open interest build up at the higher call strike prices. With this knowledge in mind, many of them got into bull call spreads or long call positions to generate a profit on the then-current trend.

Key Takeaway

In this case study, the Tesla stock saw a significant increase in open interest for out-of-the-money (OTM) call options. When you combine higher OI with a rising stock price and falling put-call ratio, you have a recipe for bullish sentiment in the market for Tesla stock that came right before a considerable rally (the asset’s price seeing a sustained upward momentum).

S&P 500 Index (SPX) — Open Interest Clusters Before a Downturn

Background

Many traders and investors had uncertainties above the S&P 500 in the early parts of 2022. Considered a volatile period for the index, the S&P was hovering right around 4,500 and there was speculation that the market might reverse course due to a more bleak economic outlook and interest rates that were on the rise. Some theorized that the market would continue to climb. What was a trader to do in a situation such as this? They would use open interest, of course, to gauge when the market might be headed.

Open Interest Analysis

A significant signal came in the form of an open interest change somewhere in the middle of the year. Eagle-eyed traders saw a considerable increase in open interest at 4,400 and 4,300 put options. This showed that prominent traders and institutions were speculating on a drop-off, and they were building protective positions to insulate themselves against the downturn.

In addition, there was the put-call ratio to consider. This had spiked above 1.2 which was showing there were a lot more put buyers than call buyers. Any good trader knows that this is a signal of bearish sentiment in the market. One could also see a lack of bullish moves on the part of other traders as open interest remained at a call strike price above 4,500, still relatively low.

Traders could glean another clue in this situation in the form of usual spikes in open interest. You could see these out-of-the-ordinary spikes on deep-in-the-money puts. This analysis of open interest suggested that prominent traders and large institutions were positioning themselves in a way to deal with the effects of an economic downturn in the market. These open interest clusters were the primary clue.

Price Reaction

Fast forward to two weeks later and the S&P 500 fell from 4,500 to 4,250. The rising interest rates and uncertainties of the future of the economy had indeed proven the bearish suspicions that many investors at the time were feeling and it was reflected in the changes that happened with open interest where there were spikes around put options.

The experienced traders with the foresight to look for the rising put-call ratio and keep an eye on the growing open interest in put contracts had the time to put some bearish strategies into practice before the S&P 500 took a severe downturn. Based on the prices they were seeing, traders could begin using put debit spreads or simply buy put contracts to profit from the downturn.

Key Takeaway

The primary lesson learned from the S&P 500’s performance in 2022 is that a significant surge in open interest around put contracts at key strike prices, along with a higher-than-usual put-call ratio, can be a strong signal that the market is going to experience a considerable downturn from where it currently sits.

Lessons from These Case Studies

Four primary lessons can be learned from these two examples of Tesla and the S&P 500. We’ve outlined them to give you a clearer idea of how the lessons could be applied to real-life usage of the open interest when you’re trading options online.

1. Pay Attention to Open Interest Build-Up: In the S&P 500 example, there was a build-up of open interest around put options that was giving off a clue that the market was likely to experience a downturn. Open interest buildup at key strike prices is a strong indicator of where market participants expect price action to move, and with all the big money investors making these moves to guard against price downturns, retail traders could have taken this as a cue to buy some put options of their own.
2. The Importance of the Relationships Between OI, PCR, and Price Movements: The relationship between open interest, price movement, and Put/Call Ratio (PCR) helps traders gauge whether momentum is bullish or bearish.
3. Institutional Traders Leave Footprints: What we mean by this is that there are telltale signs that institutional trading is afoot and you can see it clearly with open interest data if you have a keen eye for options trading. For instance, surges in open interest around put options could be a sign that more experienced investors are bracing themselves for an economic downturn, even though retail traders might not be seeing it. Traders should be monitoring these changes, which can provide them with an edge.
4. Use Unusual Spikes in Open Interest to Your Advantage: When traders see spikes in open interest without corresponding volume, this is a strong indication of new positions being opened, which can be early signals of market movement. Use this signal to your advantage to capitalize on a strengthening trend or market liquidity.

Tools for Tracking Open Interest

When it comes to tracking open interest in a fast-paced trading environment online, it’s best to have the more robust and nimble tools at your disposal to get the job done right. Check out the best free and paid tools for monitoring open interest, the ones we feel will give you a satisfying experience watching this key technical indicator.

• ThinkorSwim (TOS): Navigate to the Options Chain where you can select “Volume, Open Interest” and find the data for both calls and puts. Traders can also access the put-call ratio under “Today’s Options Statistics.” Display the open interest study plot on the volume subgraph when selecting “Show Open Interest.”
• OptionStrat: This platform has a heatmap that visualizes open interest distribution by strike price and expiration date. Some other relevant tools offered include unusual options flow, profitability calculators and optimizers, and liquidity warnings.
• Unusual Whales: Traders using this platform can analyze open interest by going to “Open Interest Change Feed” and “Contract Lookup” which display the most relevant information like open interest and historical volume data. There are even open interest filters that work like flow and screener pages.
• NASDAQ Option Chain: This platform carries open interest tools along with other key metrics like volume, implied volatility, bid/ask prices, and many others. The options chains offered by NASDAQ display all available options for each security, including strike prices, expiration dates, and call or put options.

Common Pitfalls When Using Open Interest

Don’t fall victim to these common mistakes when using open interest to gauge public sentiment or upcoming market trends. The more you can steer clear of these pitfalls, the better off you’ll be in the long run.

• Ignoring Other Indicators: Open interest should not be used in isolation. Get into the habit of combining it with volume at the very least, but then work other technical indicators into the mix to get a clearer picture of what’s going on in the options market. Pair open interest with three of four other indicators, and you should have a good gauge of market direction and trend continual or reversal.
• Misinterpreting OI Changes: Not every increase in OI means new positions. Some traders might make the mistake of thinking that open interest upticks represent new money entering the market, but that’s not always the case. Sometimes, it’s due to existing positions being transferred between traders and not entirely new positions being created.
• Failing to Track Expirations: OI naturally drops after expiration cycles because those contracts either expire as worthless or are exercised which results in the closing of positions and a reduction in the number of open contracts. Closing out positions before the expiration date reduces open interest as do exercise and expiration. If you don’t keep an eye on the expiration date, you could set yourself up for a situation where your position loses open interest.

Open Interest in an Invaluable Tool For Options Traders

Knowing what open interest is and how to read it correctly when getting a gauge for the condition of the options market is key for traders or investors who want to figure out the strength of a market trend or experience liquidity with the positions they trade. Traders can also leverage open interest numbers to determine market sentiment, confirm trends, and predict potential price movements. Perhaps most importantly, traders can monitor open interest changes daily to anticipate potential market shifts.

To use open interest effectively in your trading sessions, it’s best to use it along with other technical indicators like volume, price action, or put-call ratio to gain the best possible insights. Never use open interest in isolation and expect to make the right trade moves. If you’re new to trading options and reading open interest data, it’s best to trade with a demo account or paper trading simulator to get a feel for it before diving into the live market with real money!