When you examine an options chain, there will be a column that's titled open interest, which can be a very useful tool for options traders.
The open interest shows all open options contracts that are available for exercise have not been closed out. For example, if you opened or initiated a trade by purchasing 10 IBM call options from an options seller who was also opening his position, the open interest column would increase by 10 contracts, in other words 10 contracts would be added to today's open interest.
If you decided to sell or liquidate your position and sold your 10 IBM contracts to someone who was also closing out their position, open interest would be reduced by 10 calls.
One way traders use open interest is to determine supply and demand levels for the underlying asset. For example, let's assume that you are looking to buy a call options for ABC stock that's priced at $50.00 per share and you believe that the stock is going to go up to $70.00 per share within the next 3 months. When you look at the call options that expire four months from now, you find that the open interest on the 70 strike price call option is only 10 contracts, while the open interest on the 60 strike price call option is 500 contracts.
This tells me that the majority of speculators don't believe that the underlying stock is going to move up to $70.00 in the next three months and I may want to consider buying a lower strike price call option or reconsider the trade because the sentiment is against the stock moving up to $70.00 per share during the next few months.
Another very simple way to use open interest is to determine whether the overall sentiment on the underlying assets that you are analyzing is bullish or bearish. Let's say that you are looking at ABC stock and once again the stock is priced at $50.00 per share. When you look at the open interest column the 50 strike price call option have open interest of only 100, while the 50 strike price put option has open interest of 500.
This would tell me that the current market sentiment for this stock is bearish, since open interest is 10 times higher for the at the money put option compared to the at the money call option, this would tell me that the current sentiment favor ABC stock moving lower.
If on the other hand the at the money call options had higher open interest than the at the money put options, then I would conclude that the sentiment is bullish.
If on the other hand you find that open interest for the at the money call option and the at the money put option to be similar to each other, then I would avoid using open interest as a directional sentiment indicator. I find that it works best when the open interest numbers favoring either the calls or the puts outweighs the other side by a very large margin.
Lastly, another very common way of utilizing open interest is to monitor for unusual options activity. For example, if ABC stock is trading at $50.00 and the $60 strike price call option that expires in 1 month has open interest of 10,000 contracts and within the next few trading sessions the open interest dramatically rises, this would imply that speculators are accumulating that option because they believe ABC stock is going to move higher within the next few weeks. Similarly, if the open interest drastically increased in a short period of time in an out of the money put option, the $40 strike price for example, it would imply that speculators believe that ABC stock is going to move lower.
Screening for unusual rise in open interest is so popular that several financial analysis firms specialize in screening for options with major changes in open interest in a short period of time.
I personally find that keeping an eye on stock index open interest levels, for different options strike price levels, offers me an excellent analysis tool for short term price swings as well as support and resistance levels.
Wishing you the best in your trading.