What is open interest in trading and how to interpret it?

Open interest is a metric used to measure the activity and liquidity of a particular market. Along with other indicators, open interest helps identify possible changes in market sentiment. How is it calculated and how can it be interpreted?

What is open interest?

open interest (or open interest in French) is a measure of the total number of open contracts that have not yet been settled or closed in a particular market or security.

This metric is commonly used in futures and options markets to assess the performance and liquidity of a particular contract or market. It is usually calculated on a daily basis and can be used to identify trends and changes in market sentiment. This indicator covers long and short positionsbullish and bearish betting positions respectively.

Open interest is not necessarily a direct indicator of the direction of price movement. This can be influenced by various factors, including market conditions, supply and demand dynamics and investor sentiment.

A high open interest may indicate an increase in the price volatility of the monitored asset. Along with other indicators, open interest can help the trader identify potential market highs or lows.

Combined with other indicators, open interest can help the trader identify potential highs or lows in the market. But how should we interpret increases and decreases in open interest?

If open interest increases

An increase in open interest indicates that new contracts are being added to the market. This could be a sign of increased buying or selling activity as traders and investors take new positions. Therefore, an increase in open interest can support both an uptrend and a downtrend in the price being studied.

If open interest declines

A decrease in open interest indicates that existing contracts have been closed or settled. This could be a lack of interest or a change in sentiment as traders and investors offset or liquidate their positions. Such a situation can lead to a long/short squeeze caused by a sudden price movement.

Interpret open interest based on other metrics

The chart below shows an interpretation of market behavior based on changes in price, volume and open interest.

open interest Asset price The volume of the pair Market sentiment
was raised To ascend To ascend Taurus
was raised To fall To ascend Bear
Weak To ascend To fall Bear
Weak To fall To fall Taurus

Only this information do not confidently indicate market sentiment due to obvious open interest, but it can help determine if it is accompanied by other indicators.

Example with Bitcoin (BTC).

Let’s say a trader is interested in Bitcoin (BTC) and wants to trade it in the futures market. He decides to start a “long” position by buying a Bitcoin futures contract. This will result in an increase in open interest in Bitcoinadded to the market as a new contract.

Now imagine that another trader starts a “short” position in Bitcoin with a futures contract. This would also increase open interest in the contractadded to the market as a new contract.

At this point, open interest in the Bitcoin futures market is two contracts. Both traders have initiated positions, but neither has yet specified or settled their futures contract.

Now suppose that the first trader decides to liquidate his “long” position by selling the futures contract he bought earlier. This will result in a reduction in open interest in a contract because one of the two existing contracts has been closed or settled.

On the other hand, if the second trader decides to liquidate his “short” position by buying back the futures contract he previously sold, this will also result in a reduction in open interest.

In this example, open interest in the Bitcoin futures market started at zero, increased by two when both traders initiated their positions, and then decreased by two as the traders closed their positions. Open interest can be a relevant measure for traders and investors to monitor market activity and liquidity.

Figure 1: Evolution of open interest in Bitcoin from March 2020 to December 2022

Conclusion about open interest

An appropriate metric to track the evolution of market activity, however, open interest should be studied along with other indicatorssuch as price trends, volume and volatility.

In addition, not all cryptocurrencies have futures markets and therefore their prices cannot be studied with this metric.

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Graphic Source – Image 1: CoinGlass

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