This article explains what the effect of open interest is on options, and how we construct an indicator based on this data. This indicator was developed here and is called ‘Open Interest Index’ or OIX.

The full version of this article was published in the Nov’03 issue of Stocks & Commodities Magazine.

## What is open interest?

Open interest is the number of open contracts of a given option. An open contract is either ‘long’ or ‘short’ that is not exercised, closed or expired. One unit of open interest represents always two parties, 1 buyer (long) and 1 seller (short). Open interest increases when a buyer opens a long position (and thus at the same time) a seller opens a short position. Open interest decreases when a buyer sells/closes a long position and thus a seller closes/covers a short position.

Open interest can be used for analyzing two things:

- Trends
- Expiration

## Trend Analysis

Using open interest we can see the strength of a certain stock. We can see if money flows in or out of the market. It can be used to determine a change in the current trend.

- Increase in volume and open interest confirms the current trend
- Decrease in volume and decrease in open interest is a signal for the current trend to end

## Expiration and open interest

On the Amsterdam option exchange, every 3rd friday of the month is expiration day. A number of option series expire on this day. The expiration price of the AEX index is determined by averaging values between 15:30 and 16:00. See this chart below.

At expiration all call options with a higher strike price than the expiration price of the underlying stock/currency or index will be worthless. All series with a lower strike price will have value and will be exercised. In the case of put options the opposite applies.

Statement 1: For all holders of short positions it will be optimal when the value of the positions at expiration is as low as possible. The total amount of money that the ‘shorts’ have to pay the ‘longs’ can be calculated using the open interest, the strike price and the expiration price.

Example: A stock expires on 52,-. The open interest of the call option 50,- is 541. The value of every contract is thus 2,-. One contract represents a 100 shares so the total amount of money is: (52-50)*541*100 = 108200,-

If we do this for all option series (=strike prices) we get the following chart:

The chart show that around a price of 345 the total amount of money is the lowest. This is the optimum expiration price.

This is also where the most remaining open contracts will expire worthless (= out of the money).

Statement 2: All parties of short positions together want to pay the least amount of money at expiration. Therefor they want the expiration price to be the optimum expiration price.

In reality both private investors and professional investors will hold short positions. However, because of their size only professional parties can influence the share price by buying or selling large amounts of stock. Professional parties can be pension funds, banks, holders of mutual funds and market makers.

If the current price is too high then they will try to lower it by shorting (selling) stocks. In case of index options they will sell index futures. If the price difference is really big or if the price doesn’t go down because of external factors (or if they have no stock left to sell) then it will be useless to sell their stocks. In that case they have to cover/hedge their short positions in case they get exercised. So they have to buy(!) instead of sell. However by buying the stock price will go up. This is called a short squeeze.

Open interest can be used to calculate the total amount of money of all open contracts at the current stock price.

Open interest based trading

Using the above we can say the following:

When expiration is coming closer the price of the underlying stock will move in the direction of the optimum expiration price because of pressure from within the options exchange. This will be both in the upward as in the downward direction. There is one exception: If the price difference is too big then the opposite will happen, a short squeeze

As an example we take the AEX index. The graph shows both the stock price and the optimum expiration price (yellow) calculated for each day:

Chart: Open Interest history

The chart above was made by calculating the optimum expiration price every day based on the open interest of that day. As you can see, the yellow line changes much slower than the actual stock price.

## OIX Oscillator

The OIX oscillator was developed to show how close or far the index was away relative to the optimum expiration price. It is basically an overbought/oversold indicator but is using the expiration prices.

## Trading based on open interest

Given the above a number of ideas can be formulated for trading based on open interest:

- Open positions on the Monday of the expiration week
- Only open a position if the stock price and optimum price have a significant difference
- If a short squeeze is expected then go long
- Is the share price too low then go short
- Is the share price too high then buy puts or sell calls
- Close your position on thursday or friday at least some time before expiration, since in the last half hour of expiration volatility can increase.

Since this indicator contains information about future price expectations (=options contracts) it is a leading indicator (as opposed to lagging).

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