The analysis of any market requires time, hard work and patience. Therefore, whenever investing in a financial market, it is important to do so with the right share of research and the right tools at your service. Keep in mind that market investments are subject to a variety of risks and fluctuations which is why for traders, every little clue and indicator can be important.
Two of the most commonly used indicators in the analysis of financial markets are open interest and trading volume. In particular, they are an effective means of gauging the market flow and sentiment in futures and options contract trading. Both of these features serve as essential technical guides that help traders determine price movements, price direction and liquidity within the market.
There can, however, be a fair bit of confusion in determining the difference between open and volume, especially for new traders. To better understand these two concepts as well as what sets them apart, let us take a look at these key points:
Understanding Contracts: Options and Futures
Since open interest and trading volume are most often used in futures and options trading, let us first review how these operate. Futures and options are forms of legally binding agreements, or contracts. They allow traders to buy or sell securities, such as stocks or commodities, at a predetermined price on or by a predetermined date. The value of these contracts is essentially determined by the value of the underlying assets.
As a result, trading in contracts such as futures and options requires traders to be informed and aware of every price movement of the underlying assets. That is why they employ intensive technical analysis and make use of indicators such as volume and open interest to manage their risks and maximise their earnings.
What is Volume in Trading?
In terms of contracts trading, volume refers to the measure of contracts traded within a specific period of time for particular security. It is measured right down to the number of each transaction, that is every option and future contract traded between buyers and sellers, for that security.
If the contracts for a security are traded actively, it reflects in its trading volume with a high figure. If the security is not being actively traded, its trading volume will be low. These figures of trading volume for respective securities are tracked by the market exchange. They are updated throughout the day and the final figure of daily trading volume is calculated at the end of trading day.
Why Does Volume Matter in Trading?
To understand the distinction between open interest vs volume, let us first understand why the latter matters in contracts trading. Trading volume is an indicator of market activity of a security and directly reflects its liquidity in the market. High trading volumes suggest to the traders that there is an active interest for the security in the market and opportunities for better order executions.
The most effective method of making use of this indicator is to focus on the average daily trading volume figures of a security. For instance, if the average trading volume of a security is higher than usual and is accompanied with a price change, it might be an indication of a favourable opportunity. Therefore, trading volume can be used as a means of validating the importance of certain price movements and direction.
What is Open Interest in Trading?
Next, let us differentiate between open interest vs trading volume by exploring the former. Open interest can be defined as the number of active or outstanding future and options contracts for an asset, at a given point of time. It represents the positions for a security in the market that have, for whatever reasons, not yet been closed.
Open interest serves as an indicator of the trading activity for the asset and shows whether capital into its futures and options market is increasing or not. Unlike trading volume, open interest is updated less frequently at just once per day.
Why Does Open Interest Matter in Trading?
Open interest increases when new contracts are created and decreases when positions in an existing contract are closed by the buyer and seller. Therefore, it is used as an indicator of the liquidity and market activity for a security. High or rising open interest indicates that there is a large number of buyers and sellers for that security. This implies that trading in that security will be easier and quicker since there is an influx of money flowing in the market.
On the other hand, low or decreasing open interest in a security indicates that market participants are not opening any new positions and closing out any current ones. The market for that security, therefore, is drying up and is not ideal for a trading opportunity.
Both trading volume and open interest are crucial factors that can influence the decision making process for contracts traders. As far as the open interest vs trading volume distinction is concerned, they are both significant in their own ways. They both make up an important part of any trader’s toolkit and help identify opportunities as well as potential entry and exit points in the market.