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Please define Option Open Interest, its interpretation, and why it matters?

From my understanding, option open interest describes the net of long-short outstanding call or put options. But I do not understand, why this would number would matter.

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You are generally correct with your definition of open interest. It is the total number of "open" contracts for example contracts that have not been closed by a liquidating trade, exercised, or assigned. For example, if one party buys a call and another sells the call option the open interest on that option is now 1. Open interest can be important for a number of reasons:

  • It can indicate which strikes are most liquid. If more people who hold positions in a certain strike generally that means the strike will be more liquid. This means the bid ask spread on options with lots of open interest might be relatively tighter.
  • More interestingly open interest can reveal large trades that other people are putting on. For example if you see a huge amount of open interest on in the money options going into a dividend it is possible someone is making a dividend play. Another example is if you see a abnormal amount of calls and puts on the same strike on a stock with a large percentage of its shares shorted this could mean people are turning to the options market and selling calls and buying puts at the same strike to form a synthetic short underlying position (Synthetic Short Explained). They might do this if they are having trouble finding shares to borrow.
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  • $\begingroup$ Thank you for your explanation. I cannot fully follow your initial example at the moment. When you buy a call, someone else always must have sold it. So the net of long and short calls would always be zero? And does open interest somewhat track individual calls and their holders, or is it just an aggregate number? $\endgroup$ – emcor Sep 26 '16 at 13:43
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    $\begingroup$ It is not a measure of the net position. Since someone bought one call and someone sold one call then 1 contract has been created. This is what open interest measures. The OCC (options clearing corporation) keeps track of open interest but they don't necessarily have to keep track of every individual person to calculate it. Trades are marked "to open" or "to close" when they are made and the OCC can use this information to determine open interest. For example, if there are more trades market "to open" open interest would clearly increase. $\endgroup$ – klib Sep 26 '16 at 13:52
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    $\begingroup$ The information can also be useful if you're building surfaces from the data, using open interest as part of the weighting in any fits. $\endgroup$ – will Sep 27 '16 at 7:05

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