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Open interest (OI) is a metric that shows the total number of outstanding derivatives contracts, such as futures or options, that remain unsettled. OI is used by traders to measure market activity and sentiment towards a specific asset. The metric achieves this by showing the total number of active contracts at a certain moment in time.
If you’re looking to trade crypto derivatives products in available markets, it’s worthwhile to understand what open interest is, how to calculate the metric, and how you can use open interest to inform your trading strategy. Read on as we explore these areas.
How to calculate OI
The formula for calculating OI is relatively simple. All we need to do is add the total number of open long positions to the number of open short positions. However, keep in mind that this total is always changing as buyers and sellers open and close positions.
Here's how the changing buy and sell positions impact the OI total, using the scenario of two traders entering into a contract.
Trade | Impact on OI |
|---|---|
Two traders each open a new position | OI increases by 1 |
One trader closes their position, the other's remains unchanged | OI decreases by 1 |
A position is transferred to a third trader | OI stays the same |
Benefits and limitations of OI
Before measuring OI as part of your trading strategy, it's wise to understand the benefits and limitations of the metric, as part of your wider research.
Benefits of open interest
Reduced trading costs: Higher OI typically indicates deeper liquidity, making it easy for traders to enter and exit positions. This increased trading activity results in more narrow bid-ask spreads that allow for reduced transaction costs and slippage for active traders.
Gives context to market sentiment: OI could be used to back up other evidence of a shift in trader sentiment, reinforcing any wider technical analysis you've completed.
Transparency to market activity: Because OI reveals the number of unsettled contracts for an asset, you gain valuable insight into market engagement, allowing you to make more informed, data-driven decisions.
Simplicity: Because you can quantify OI through a calculation, it's one of the simpler metrics you can use for technical analysis. As a result, OI can be adopted by beginner traders right through to veterans.
Limitations of open interest
It's a lagging indicator: As OI relies on past data to provide a measure of what's already happened, it can only confirm a trend after it's started. This could lead you to miss potential gains if you open a position after prices have already moved.
It can be misleading without additional context: By now we know that OI can be most effective when it's combined with other metrics. However, that means OI could be misleading if it’s viewed without context, potentially leading you to incorrect conclusions.
Lacks directional detail: OI shows the total number of unsettled contracts, but not whether they're bullish or bearish. Further analysis is needed to place OI in context and allow you to make a fully informed trading decision.
Using OI in your crypto trading strategy
Now that we've got a clearer picture of what OI is and its benefits and limitations, how can you apply the metric to your trading strategy? Here are three ways many traders use OI.
Understand market participation
Some traders measure OI alongside price action for insight into market participation. Rising OI and prices could suggest growing trading volume. On the other hand, falling OI could suggest that positions are being closed, pointing to weakening momentum.
Suggest possible trader sentiment
Because open interest sometimes shows a correlation to market volume, some use it to judge possible trader sentiment. Rising OI and prices could suggest positive sentiment, while the opposite scenario might suggest more fear in the market.
Help spot trends
Other traders use open interest to identify trends, and once again, volume is a key metric often included for this purpose. Rising OI coupled with rising volume could suggest a trend is strengthening, because increasing OI points to new money entering the market. The question then is: in what direction is the trend moving? Price action can help to answer this. Rising OI and volume during a period of downward prices could suggest a continuing bearish trend — and vice versa, when prices are rising.
The final word
Open Interest is a useful metric to understand when completing technical analysis in the sometimes complex derivatives market. Although OI is often most effective when measured alongside other factors, its simplicity and transparency mean the metric is accessible for beginner traders as they can quickly gauge existing liquidity in the market.
Interested in learning more about derivatives trading? Our essential guide is a good place to start, alongside our explainer article on trading BTC derivatives.
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