Everything you need to know about using open interest in trading

Everything you need to know about using open interest in trading

article by CryptoJelleNL

Open interest is an advanced trading indicator that is most popular among derivative traders. It helps traders understand the number of open positions on a certain derivative contract, be that in crypto or stock markets! In todays article, we dive into what OI is, how it works, and how you can apply it in your technical analysis – even if you don't trade derivative markets!

Refresher: A derivative is a financial instrument that derives its performance from the performance of an underlying asset. The most common types of derivatives are futures, options, forwards and swaps.

What is open interest?

Traders use open interest (OI) to track the number of open positions on a particular contract, such as Solana perpetual futures, or a specific soy-bean option contract. With open interest, they track the total number of outstanding derivative contracts – or the total active participation in the market.

This makes tracking OI different from tracking trading volume, as the latter includes both opened and closed positions, whereas OI only looks at the currently open positions, both long and short. The common belief that open interest is the sum of all buying and selling transactions is therefore wrong.

Studying OI helps traders understand if new money is flowing into the contract, or if people are closing their positions, which can yield insights into the excitement of participants, the available liquidity, and more!

How does open interest work?

Because open interest tracks the number of open positions in a market, it increases when more contracts are opened than closed – and decreases when more contracts are closed than opened.

Let's take a look at a simplified example. If Bitcoin's OI is currently at 35, and trader Peter opens a trade with 100 contracts, OI increases by 100, to 135. When Fred closes his short worth 55 contracts, OI drops down to 80, and so on.

Now of course, these trades need another side to match them – and this is what makes OI complicated. The real effect of a trade on OI depends on who takes the other side.

Namely, if a long is closed, but a new trader buys those coins again, OI remains unchanged. If that long is closed, and someone else closes his short too - OI drops, because the two closed positions cancel each other out, and there are now less open positions in the market. Similarly, if you enter a long with the liquidity of someone entering a short, OI increases, as two new positions were just opened.

The reality is that OI is a constantly updating calculation of open positions, as new trades are executed every second.

Open interest vs. Trading volume

As mentioned earlier, OI and trading volume are often confused, but they are very different. Open Interest tracks the total open positions on a contract, whereas trading volume is the sum of all transactions added together.

If we calculate the trading volume for the previous simple example, we come to a total of 155, even though OI sits at 80. Alternatively, if Peter would sell 50 of his contracts to someone else, OI would remain unchanged, whereas the trading volume would increase by 50.

Therefore, it is important not to confuse the two.

Interpreting open interest

Generally speaking, analysts use OI to determine the strength of a price trend. An increase of OI is often seen as confirmation of a trend, but if OI increases too quickly after a strong pump, many traders interpret it as "chasing the pump". Most of the time, a decrease in OI suggests the end of a trend, as positions are being closed. As you can tell, analyzing open interest is not an exact science.

Nevertheless, the majority traders interpret OI with the following assumptions:

  • If price increases, and OI increases as well – the move is strong. (new positions entering)
  • If price decreases, but OI increases – the move is strong; (new positions entering)
  • If price increases, but OI decreases – the move is weak; (taking profits)
  • If price decreases and OI decreases as well – the move is weak  (taking profits)

As discussed earlier, there are exceptions to these assumptions. For example, if OI suddenly skyrockets after a correction – you could interpret this as a sign of eager dip-buying, which suggests there may be more pain coming. Essentially – OI is not a tool to be used on a stand-alone basis, but can add further information and confidence to your analysis.

Why use open interest in crypto?

Open Interest is one of the most accurate gauges of market activity, which makes it a fantastic addition to your suite of analysis tools. It can show the degree of liquidity, but also help you better understand whether traders are getting in or out of the market. This insight can be useful for spot traders as well!

All in all, a useful tool to learn more about.

How to find open interest data?

Depending on the market, there are various open interest sources. When looking for open interest data from the crypto markests, the following sources can be useful:

  • CryptoQuant – Open Interest data for BTC perpetual futures pairs.
  • TheBlock – Advanced charts and open interest data, volume and funding rates on many crypto futures pairs.
  • CoinGlass – Aggregate open interest data for major coins on the top exchanges.
  • Coinalyze – Open Interest data for BTC perpetual futures pairs, and aggregate open interest data for altcoins.

There may be minor differences when looking at different data sources, so it is good to experiment and find the source that works best for you.

Closing thoughts

All in all, open interest is a powerful analysis tool that is especially useful for options and futures traders. While it yields valuable insights, it is not a foolproof tool, and can print misleading signals from time to time.

As always, traders should exercise risk management, and use open interest analysis in combination with other tools, rather than on its own. We wish you the best of luck in refining your trading strategies, and we hope this article proves to be useful on that journey.

Author's Disclaimer: This article is based on my limited knowledge and experience. It has been written for informational purposes only. It should not be construed as trading or investment advice in any shape or form.

Editor's note: CryptoJelleNL provides insights into the cryptocurrency industry. He has been actively participating in financial markets for over 5 years, primarily focusing on long-term investments in both the stock market and crypto. While he watches the returns of those investments roll in, he writes articles for multiple platforms. From now on, he will be contributing his insights for Alpha Circle as well.

Check out his twitter: twitter.com/cryptojellenl

The content above is neither a recommendation for investment and trading strategies nor does it constitute an investment offer, solicitation, or recommendation of any product or service. The content is for informational sharing purposes only. Anyone who makes or changes the investment decision based on the content shall undertake the result or loss by himself/herself.

The content of this document has been translated into different languages and shared throughout different platforms. In case of any discrepancy or inconsistency between different posts caused by mistranslations, the English version on our official website shall prevail.

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