Is Open Interest the Missing Signal in Options Trading?

Is open interest the overlooked signal that reveals where real risk and conviction are building in the options market? Market Chameleon’s Dmitry Pargamanik and Will McBride break down how traders can interpret open interest alongside volume and implied volatility to better understand positioning, sentiment, and price discovery.

Summary – IBKR Podcasts Ep. 341

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi everyone. This is Jeff Praissman with Interactive Brokers. It’s my pleasure. Welcome back to our podcast studio from Market Chameleon, Will McBride and Dimitri Matic. Hey guys, how are you? 

Dmitry Pargamanik 

Hey Jeff. Thanks for having us. 

Will McBride 

All is good, Jeff. Happy New Year, my friend. 

Jeff Praissman 

Happy New Year, guys. And you know, always one of the highlights of my months to have you guys in for the monthly webinar. And then when you guys swing by the studio afterwards, we do, I guess, a different dive on the subject. And today, you know, we had the pleasure of listening to your webinar on open interest. For our viewers, I think it’s best to start ’cause open interest is tricky. Right, guys? Maybe just if you guys could start with the fundamentals of it. You know, it’s sort of an odd—not an odd subject is the wrong word—but, you know, sort of different. It’s different than volume. So people, I think, newer traders get a little bit confused. If you can kind of give ’em the key distinctions, Will and Dimitri. 

Dmitry Pargamanik 

Yeah, thanks, Jeff. And yeah, I think the important thing to understand is open interest in options. It’s not the same thing as volume. Volume is trading volume, which just represents the contracts that are transacted on a day. The open interest, on the other hand, that’s a calculation by the Option Clearing Corporation, and it represents the amount of contracts still open, not closed yet. 
So these are cumulative over time, not just on the day’s trading, but these are contracts that are still held, not closed or expired by market participants. And they’ll accumulate throughout—you know—the open interest can climb from day to day or decline. But this is the total number of open interest over time. 

Jeff Praissman 

And so maybe kind of like a practical example would help. So, you know, what does it mean or can you explain when, let’s just say, 50,000 contracts trade in a strike, but at the end of the day the open interest only increases by 5,000, you know, versus, you know, either 25,000 or 50,000 or whatever? 

Dmitry Pargamanik 

Yeah, no, that’s a good question. A lot of people look at volume and think that the volume automatically updates with the open interest, and open interest is not actually updated like trade transactions in real time. It’s calculated overnight based on several trades. And when we look at the volume throughout the day, well, you could have volume that does increase open interest. You could also have volume that is opened and closed on the same day. You know, like short-term trading activity where by the end of the day the open volume in the morning is closed by the end of the day. That will not increase the open interest the next day. Or you have volume that is traded, but it’s just transferred from one—risk transferred from one—trader to a different trader. But if that open interest existed, that will not increase open interest as well. So you can see a lot of volume on the day, and then the next day you’ll see perhaps very little open interest, but it will not correlate to that entire day’s volume from the previous. 

Jeff Praissman 

And could you kind of explain why open interest might matter even more than volume, sort of in assessing trader sentiment? 

Dmitry Pargamanik 

Yeah, so the interesting thing about the open interest and what it tells us is that these are positions that are held, you know, and risk held currently in the marketplace by players. So it shows conviction. And open interest, you know, unlike volume—we could trade in and out and close out of the position—but the open interest is indicating that people still carry this risk. They still have opening positions, and it could tell us a lot of things, especially if we’re seeing open interest—not volume necessarily—but if we see open interest climbing. That could indicate where there’s an accumulation, you know, a buildup of risk over time. Declining would mean exiting. And that doesn’t always correlate with volume because we could see a lot of volume on a day, even from day to day, with open interest not growing. So that’s—you know—the open interest tells us something different than the volume, and it’s important to look at it from those perspectives. 

Jeff Praissman 

And kind of to go further on that point, like when you see open interest increasing, are you able to determine, you know, whether it represents new bullish positions or bearish positions or hedging activity, or even—can you use open interest for multi-leg strategies? Kind of like what other data points you use to decode it. 

Dmitry Pargamanik 

Yeah. So when we look at open interest, we can look at it as an aggregate, like open interest, for example, in this specific stock increasing across the board. And then we can look at it at granular levels. Where is the open interest increasing? But it’s concentrating in a particular option, or a particular expiration, or cluster of options. And while we don’t know the intent of each trader—who the traders are—that’s anonymous. But there are certain places where if we see open interest increasing on a particular expiration or a particular strike, you could make inferences. You know, if we were seeing open interest increasing on mostly out-of-the-money calls, you know, what’s happening in those calls? Why are people particularly interested in this call? Because each call or each expiration tells you something different.  

And that’s kind of where we start at the top and then have to dig deeper to make more inferences. Where is this increase in open interest coming from? Is it concentrated? Is it dispersed amongst many different options? Is it concentrated in expiration? So those are the types of things where you’d start to do more granular research. 

Jeff Praissman 

And then on the other side of that, you know, if open interest is decreasing dramatically—especially if it’s going down dramatically—what are some scenarios that could drive that? 

Dmitry Pargamanik 

Yeah. So when we see open interest decreasing dramatically, really it’s indicating that people are exiting positions. They’re closing out positions. And you’d see that a lot of times—typically after earnings announcements—where open interest grows either due to hedging, speculation, whatever. And then right after earnings, you’ll typically see trading activity that ends up in open interest decreasing, which just gives you the indication that those trades were based on that event. Whatever happened during that event, the next day those positions are just being closed out, win or lose. They’re exiting that position and moving on. They’re not holding on to those options for longer-term goals. 

Jeff Praissman 

And you know, we talked in the past about the difference between smaller trades or big block trades, like with open interest. Is there implications of it rising from a huge, large block trade or, you know, like hundreds of small scattered trades? How does that distinction kind of change your interpretation of it? 

Dmitry Pargamanik 

Yeah, exactly. When we take a look at the open interest increase, we try to understand, well, what led to that increase? You know, how did the trading, or what type of trading, led to that increase? So if we go back and look, we could look at the volume or the breakdown in the volume. And sometimes what you’ll see is an open interest increase, and it was due to maybe one block trade. You know, like say a thousand contracts traded in a day, and open interest increased by a thousand. If it was one transaction, that indicates, well, there were two opposing parties that did a trade, and it could indicate a large institution, large hedge fund, or whatever it is did a trade for whatever reason they had. They could be sticking to a certain strategy, a hedge. And we could also see something different where open interest increases from a lot of different scattered trades throughout the day. You know, small trades that accumulated, and that could tell us something different—where maybe something’s going on, where lots of people are paying attention to something, reading something, reacting to something—where it’s coming from different places and it’s gotten the attention of either retail traders or retail and professional traders. It could be a mix. But the behavior, the way that the trading activity throughout the day led to that open interest, can tell us something different behind those trades. 

Jeff Praissman  

So, I mean, we’ve talked about it a million times on our podcast in the past. I think the key takeaway is that in analyzing option activity, really there are so many data points at your disposal, whether it’s open interest, whether it’s volume, whether it’s time and sales, and other items. So you really have to look at everything. You have to look at the full picture to be able to kind of formulate an opinion. And versus just looking at one data point, that doesn’t tell the whole story by any means. And that being said, are you able to identify through open interest multi-leg trades, or even spread activity? Can you decipher between that and single-leg, or is it more that you really have to go to the volume print for that? You can just kind of say, okay, there’s 10,000 open interest contracts on the July 50 line and also 10,000 on the July 60 line, but to really know whether or not it was actually a spread, you really have to go back to the volume reports. 

Dmitry Pargamanik 

Yeah, exactly. That’s the thing with once you kind of detect this open interest change or cumulative open interest, that’s just one number there. It doesn’t tell you the full story. And exactly like you said, it doesn’t necessarily mean that if there’s open interest on this one particular option, it all came from just single-leg orders into that option. It could have been due to a spread, which gives you a different type of information—where this option’s open interest increased, but it was part of a time spread or a call spread. And that puts a completely different perspective on the trade and what position is held out there or what the objective was behind that trade. You know, if you’re doing a calendar spread, it tells you something much different than if you just bought or sold a call outright. And to do that, yes, you would have to work backwards and look at what led to this increase in open interest. Let’s say we’re looking at an increase—you’d have to go back and look at the volume, kind of infer. Sometimes you won’t be able to, but if certain trades stick out where this is what led to this open interest increase, if it was a multi-leg trade, you’d have to figure out what that trade was to understand it. 

Jeff Praissman 

All right. And I want to kind of switch gears a little bit here, Dimitri and Will, and bring implied volatility into the picture, because it’s obviously such a big part of options. So the relationship between open interest and implied volatility—can you decipher anything if open interest rises and implied volatility is also rising versus if open interest rises and implied volatility falls? What kind of dynamics are at play here? 

Dmitry Pargamanik 

Right. So then we’re bringing in different elements or factors of analysis to paint a better picture of what’s going on. And when open interest rises, that indicates there’s more interest—there’s a buildup in a position in this particular option. Well then implied volatility—we would go back and look at what was the impact on implied volatility. Similar to if there’s a lot of volume in the stock, the next question is, what was the impact on the stock price? Was it up or down? That’s how we would look at it from the perspective of options. What was the impact on the relative premium of the option? So if we’re looking at an option where open interest increased and implied volatility increased from that trading, then the inference is that people were opening positions with higher demand for that premium, where the premium was getting pushed higher and those positions were held. Those positions had conviction, and they’re still holding onto those positions. 

Jeff Praissman 

And in your webinar, you mentioned the concept of implied volatility center of gravity, really kind of—for our listeners that didn’t attend the webinar, which is saved on our website, you can always go back and listen to it whenever you want, and I definitely recommend it if you’re interested in the subject. But it kind of means identifying what volatility level most open interest accumulated at. How can traders practically use this information for practical reasons and kind of price discovery and understanding where the market found fair value? 

Dmitry Pargamanik 

Yeah, so when we keep track of the trades and trading implied volatility, ’cause that gives us the benchmark, the indicator. Well, what was the relative value of this option when we traded, right? Because the option itself, you know, it’s gonna decay because of time decay. It’s gonna change value because it has a delta. But the implied volatility gives us an indication of the relative value of that option at the time of the trade. And we talk about the center of gravity. We talk about, well, where is the most volume traded at what implied volatility? So we take kind of a VWAP measure, where we look at VWAPs of the stock, volume-weighted average price. We could do the same thing with options using the implied volatility. And by doing that, we have a benchmark of where was the meeting of the minds? Where did a lot of the trading activity occur? At what level was it established? We could compare it to the current level, but this gives us an idea of where the trading activity occurred and where the open interest still exists versus where the markets are now. 

Jeff Praissman 

And you guys have been trading options for a long time—not to date you or anything, not to make you sound old, but we’ve all been around for a long time. What are some of the biggest mistakes or maybe misinterpretations you’ve seen traders make when analyzing open interest? You know, what does it tell us, and what, maybe more importantly, what does it not tell us? 

Dmitry Pargamanik 

Yeah, exactly. It doesn’t tell us—open interest on itself doesn’t tell us the intent of the traders. It’s a number. It’s just a number that indicates something that we would have to go and further research and make inferences about. 
But it doesn’t tell us the directional intent, because options don’t have to be necessarily directional. It could be volatility, it could be a hedge, it could be a spread. It doesn’t update in real time like volume. So a lot of people look at volume and think that the open interest updates simultaneously with it, but that’s not how it’s calculated, because it’s based on settled trades at the end of the day, and it goes through this overnight process. It’s different than volume, like we discussed. It tells us the positions that are not closed out yet. So those are the common things I think people get confused about when they first look at open interest, before they really start to analyze it and get more familiar with it. 

Jeff Praissman 

Yeah, and I think you kind of hit the nail on the head there. We sort of touched on it in the beginning, where open interest could be five in the morning, and maybe 10,000 contracts are traded that day, but you don’t see it in the open interest until the next day. So you kind of really nailed it right there, where you can use it in conjunction with volume. Like, oh, there’s only five open interest and 10,000 traded, so they must be opening trades. Whereas if it’s 10,000 open interest and 10,000 traded, well, it might be opening, it might be closing. You don’t know until the next day. 

Dmitry Pargamanik 

Yeah, exactly. Or sometimes you’ll see strategies where very deep in-the-money options are used for dividend or interest rate plays. We know those dividend plays and interest rate plays, where we’ll see a large volume, and then all those options get exercised for that strategy, and there’s zero open interest the next day because they were just exercised. So exactly—it could be confusing when you’re trying to match up volume with open interest unless you understand the different dynamics that go into both. 

Jeff Praissman 

And you know, this has been great. Are there any final thoughts you’d like to leave our listeners with? 

Dmitry Pargamanik 

I think as far as open interest goes with options, it’s a very valuable metric if you use it correctly to understand how we got here. If we see this open interest, not only look at it from the perspective of what is the open interest, but use that as a starting point to see what was the history behind how we got here. That really tells the story. It opens up the real story, not just the top number on itself. 

Jeff Praissman 

Guys, thanks a lot for coming by. For our listeners, you can find more from Will and Dimitri at marketchameleon.com. They also have a morning YouTube show that they run. And also on our website, under Education, you can find they run a monthly webinar, which is super informative if you’re into options. And then we always do a podcast right afterwards to kind of continue the discussion. Guys, thanks a lot, and happy New Year. 

Will McBride 

Thanks, Jeff. Great job, D. Thanks, everybody.