Open interest is the number of open positions for a particular class of option. A class of option is defined by both the strike price and expiration date. OTC options are a different matter.
What follows is a very simplified description of the call option writing process. So lets say we start with an open interest of zero. I decide for whatever reason to write a call option on a stock, specifying the strike price and expiration date of the call option. In writing this contract, I am selling this cotract that I have created to another trader. In terms of option lingo, I am selling an option to open. Since I did not have an option to sell, I would have to write (create) an option. The purchaser of this option contract would purchase an option to open. So both the buyer and seller of the option has an "open" position in the option. A complete transaction between the buyer and seller would incremenet the open interest by a total of two, since the open interest is the net of opening and closing transactions in a class of option.
The holder of this option allows him to exersize the option to receive 100 shares of stock at the predefined strike price. He must do this before the expiration date, otherwise the option expires worthless. It does not matter weather I have stock to back this form of contractual obligation to sell stock.
When the holder chooses to exersize this option, and I am called upon to deliver the stock, I have to settle this account. I settle this account by either selling the person who is exersizing this option 100 shares of the stock that have been in my posession, or purchasing the shares of stock at market price and handing the shares over to him. So when this transaction occurs, both "open" positions in the option are "closed", so the open itnerest decrements by two.
Now, there are some basic alternatives that the seller or the buyer of the option can take to close out their position in the option. If the buyer of the option trades the option by selling it, this would close out his account with the option, which means the open interest would decrement by one. However, at the same time, the new holder of the option would end up with a new open position in the option, which would increment open interest by one. So the net result is a zero change in open interest.
If the writer of the option wants to close his position out, he can purchase a call option himself with the same strike price and expiration date. This option purchase would involve a seller who is closing his position out, therefore causing a drop in open interest by one. Also, the purchaser of the option is using the purchase to close out their open position they created by writing the same class of option. So the open interest would in this case also decrement by one.
In summation, the open interest is the net value of the open positions in a class of options. This above is my understanding of this, but I am learning too. The problem with open interest is that there is no way of determining if either sellers or purchasers of a given class of option predominate in the open interest number. This means that there may be orders to write options that have not been sold yet, or there may be orders to purchase options that have not transacted yet.
Once again, this is my understanding of the option handling process. This can be a very involved subject that does have many pitfalls for option players who do not understand the system, and what *actually* happens in the system and options trading in relationship to the underlying stock. I personally use options not for trading purposes, but as a hedge to enter a long position in a stock, for downside protection as a form of an insurace, and to write covered calls on my long position I have in a stock issue.
I hope this helps! Feedback is welcome.
Bob Graham |
