Unlike in stock trading, whereby there is a fixed number of shares to be traded (i.e. number of outstanding shares), in options trading, new option contracts need to be created when a trade is placed and there is no existing contract yet. When a new expiration month initiated, there is no open interest because there are no option contracts being traded for that month yet. As trading builds up, open interest will also increase. Now, what is Open Interest?
Open interest is the total number of option contracts that are still open (i.e. have not yet been exercised, or have not been closed out by an offsetting transaction, or have not expired).
Open interest increases when new contracts are created by options buyer and seller, whereby a new buyer takes a new long position and a new seller takes a new short position.
On the other hand, open interest decreases when both the options buyer and seller with existing position close out their respective positions and the contract disappears.
Closing out the position can be done by doing an offsetting transaction (i.e. the existing buyer sells the option to close his long position while the option seller buys back the option to close his short position), or by exercising the option.
Please bear in mind that open interest only increases when new contracts are created. Hence, when a trader who does not have a position in the option before buys from another trader who has an existing long position and want to close his position by selling his option contract, open interest does not change because a new contract is not created.
Then, what is volume in option trading and how option’s volume is different from open interest?
Option’s Volume is the number of option contracts traded during a given period of time. Hence, volume reflects the number of options contracts that changed hands from a seller to a buyer, regardless of whether it is a new contract being created or just an existing contract.
For more clarity, let’s see the examples below:
On Day 0, Open interest = 0, Option Volume = 0.
On Day 1, A buys 2 option contracts and B sells 2 option contract.
Open interest = 2, Option Volume (for that day) = 2.
On Day 2, C buys 7 option contracts and D sells 7 option contracts.
Open interest = 2 + 7 = 9, Option Volume (for that day) = 7.
On Day 3, A closes out his position by selling 2 option contracts, and D closes out part of his position too by buying back 2 of his option contract.
Open interest = 9 - 2 = 7, Option Volume (for that day) = 2.
Open interest reduced by 2, because A & D have an existing position before, so this transaction is an offsetting transaction to close out their respective positions. As a result, 2 contracts disappear.
On Day 4, E buys 3 option contracts from C who wants to sell part of his option contracts (3 contracts).
Open interest = 7 (no change), Option Volume (for that day) = 3.
When E buys from C, it does not create new contracts. E who does not have a position in that option before simply replaces C who wants to exit his long position. Hence, open interest does not change.
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