Open Interest Analysis: How to potentially grasp the market's capital flow?

As a critical indicator for options trading, open interest can help assess the liquidity of options and determine capital flows in the market.

Today, we will show you how to use the Open Interest Analysis feature on moomoo with examples.

① First of all, what is open interest?

It is the total number of active contracts held by market participants after market close on a trading day.

Changes in Open Interest:

Example：Let's look at the trading activities of investors A, B, C, D and E to see how Open Interest is calculated.

On March 1st, a new option buyer A bought one option, while a new option seller B sold one option.
This created one trading unit and increased the open interest by one unit.

On March 2nd, a new option buyer C bought seven options, while a new option seller D sold seven contracts.
This created seven trading units and increased the open interest by seven units. The total open interest became eight units, meaning more money had entered the market.

On March 3rd, option buyer A wanted to sell his one option from March 1st, while option seller D wanted to sell his seven contracts from March 2nd.
This created one trading unit and decreased the open interest by one unit. The total open interest became seven units, meaning some money had left the market.

On March 4th, a new option buyer E wanted to buy seven options, while option buyer C wanted to sell his seven options from March 2nd.
Since one party was buying and the other was selling, there was no change in open interest. This means that some money changed hands but did not enter or leave the overall market.

The changes in open interest may reflect the direction of capital flows. By analyzing open interest, we can:

• Estimate an option's liquidity

• Evaluate market sentiment

• Predict capital flows

• Forecast the trends of the underlying stock

② How to find Open Interest Analysis on moomoo?

Tap on a stock> Options> Analysis> Open Interest by Strike Price.

③ Case Study

Next, we will demonstrate how to use this tool with several examples.

I. Estimate option liquidity

Have you ever faced "liquidity risks" when trading options?

This scenario occurs when it becomes challenging to find a buyer or seller to either purchase or sell an option at the desired price, even with an increase in the underlying asset's value.

As a general rule of thumb, options with higher open interest tend to have better liquidity levels because there are more investors looking to buy or sell options, which could possibly translate into a higher trading volume.

Before opening a position, you'd better observe the open interest of a specific option, which may help predict whether the market has sufficient liquidity.

Let's look at an example.

The chart displays the open interest distribution for AAPL options with an expiration date of Nov 17, 2023, and strike prices ranging from $50 to $300.

From the chart, we can see that:

Call option with a strike price of $180 and an open interest of 90.33k.

Suppose you hold 100 contracts. It's easy for you to sell them at a price close to the market price because they are highly liquid.

Call option with a strike price of $202.5 and an open interest of 187.

Suppose you hold 100 contracts and are ready to close your position. It may be challenging to sell them at a desired price.

Therefore, if you have a bullish view on AAPL, you should consider choosing options with better liquidity, especially if they have similar strike prices.

By doing so, you can avoid facing potential liquidity risks when closing your position.

II. Evaluate Market Sentiment

We can analyze the PCR ratio (Put-Call Ratio = Put open interest / Call open interest) to potentially evaluate the market sentiment.

The general market estimate:

A low PCR ratio indicates that more call options are being traded relative to put options, which suggests that investors have a more bullish outlook on the market.

Conversely, a high PCR ratio indicates that more put options are being traded relative to call options, which suggests that investors have a more bearish outlook on the market.

The chart displays the open interest distribution for AAPL options:

Upon examination of the chart, it can be seen that the open interest for call options stands at 3.59M, while that of put options is 3.43M.

By applying these figures to the Put/Call Ratio (PCR) formula, we arrive at a result of 0.95, indicating that the market's outlook on AAPL's future trend is currently unclear.

If the PCR ratio significantly decreases, it indicates that the market is bullish about the future trend.

If the PCR ratio significantly increases, it indicates that the market is bearish about the future trend.

III. Determine potential capital flows

Observing open interest changes may help determine capital flow in the market.

If the open interest of an option fluctuates significantly in a short period, you should pay attention to options with the same strike price.

The general market estimate:

A sudden increase in open contracts may signal that the stock price would go higher than the strike price.

On the other hand, a sudden decrease in open contracts may signal that the stock price would go lower than the strike price.

Example:

If the open interest for AAPL's Call options with a strike price of $180 was 90K yesterday and increased to 200K today.

It may indicate more investors are buying this option and opening long positions. It suggests a bullish view of AAPL as they may make a profit from their trades only when AAPL rises above $180.

Similarly, if the open interest of the same AAPL Call option with a strike price of $180 stands at 200K today but suddenly drops to 90K tomorrow (before expiration).

It indicates many investors have already closed their positions early because they do not expect AAPL's stock price to rise above $180 before the expiration date.

IV. Forecast the trends of the underlying stock

In actual options trading, we can analyze the relationship between open interest, underlying stock price and trading volume to potentially predict the trends of the underlying stock.

The general market estimate:

That's what today's lesson is all about. If you want to learn more about options, please follow [Moo Options Explorer] for timely updates!