Summary of Open Interest
Open interest is the total number of outstanding contracts for a specific strike price on an options contract. It represents the number of buyers and sellers who have not yet closed their positions.
How Open Interest is Used:
- Determining Support and Resistance: The strike price with the highest open interest on the put side is generally considered a support level, while the strike price with the highest open interest on the call side is considered a resistance level.
Reasoning Behind Support and Resistance:
When a strike price has a high open interest, it signifies a significant number of both buyers and sellers are actively trading at that level. This concentration of interest can create a strong support or resistance level.
- Support: If the underlying asset's price drops below a put strike price with high open interest, option sellers may face potential losses. To avoid these losses, they might buy more of the underlying asset to hedge their positions. This buying pressure can help support the price and prevent it from falling further.
- Resistance: Conversely, if the underlying asset's price rises above a call strike price with high open interest, option sellers may be incentivized to sell their positions to avoid potential losses. This selling pressure can act as a resistance, limiting further price increases.
Key Points:
- Open interest is a useful tool for analyzing options markets.
- It helps identify potential support and resistance levels.
- The concept of open interest is based on the assumption that option sellers have more financial power (see Option Seller Margin Requirements below) and are more likely to defend their positions.
Note: Although open interest can be a valuable tool, it's essential to consider it in conjunction with other technical and fundamental analysis methods for a comprehensive understanding of the market.
Additionally, please refer to the final section of the article, 'The Decline of Open Interest as a Trading Tool,' to gain insights into the limitations of using open interest as a sole trading strategy
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| Option Contract Matrix |
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| Option Premium Matrix |
Call Option Margin: Buyer vs. Seller
When buying a call option, there is typically no margin requirement, meaning you only need to pay the premium to enter the position; however, when selling a call option (being the "call option seller"), a margin deposit is required to cover potential losses if the underlying stock price rises significantly.
Key points:
- Call option buyer: Only needs to pay the premium for the option, no additional margin needed.
- Call option seller: Requires a margin deposit to cover potential losses as they are obligated to sell the underlying stock if the option is exercised.
Reasoning:
- Limited risk for buyers: When buying a call option, your maximum loss is limited to the premium you paid.
- Unlimited risk for sellers: When selling a call option, your potential losses are unlimited if the underlying stock price rises significantly.
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| Option margins are complex: They vary based on option type (call/put), position (in/out-of-money), and whether they're naked or covered. For example, naked calls require 100% of proceeds + 20% of underlying value. Read [1] for more details. |
Put Option Margin: Buyer vs. Seller
- Put option buyer: Only needs to pay the premium for the option, no additional margin required.
- Put option seller: Needs to meet a margin requirement based on the underlying security's price to cover potential assignment if the option is exercised.
- Limited risk for buyers: When buying a put option, your maximum loss is limited to the premium you paid, so no extra margin is needed.
- Unlimited risk for sellers: When selling a put option, you could be obligated to buy the underlying security at the strike price if the option is exercised, potentially leading to significant losses if the stock price drops significantly
The Decline of Open Interest as a Trading Tool
Aditya Trivedi in the above video argues that open interest is no longer a reliable indicator for determining support and resistance levels in the latest options market.
Key Points:
- Historical Effectiveness: Open interest was once a useful tool for identifying support and resistance. However, its effectiveness has diminished in recent years.
- Shift in Focus: Traders have shifted their focus from total open interest to changes in open interest, which has also become less reliable.
- Market Manipulation: Market participants may manipulate open interest data, making it less trustworthy.
- Rapid Changes: Open interest can change rapidly, making it difficult to use as a reliable indicator.
- Alternative Indicators: The author suggests focusing on price action and other technical indicators rather than relying solely on open interest.
Overall, Aditya believes that open interest has become outdated and unreliable as a trading tool.
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