Open Interest Configuration

To analyze stocks, we often use option open interest as a means of measuring the relative levels of investor optimism and pessimism. Open interest is the number of outstanding contracts on an option class or series. Open interest will increase by 1 contract when a buyer enters a new long position while the seller is entering a new short position. Open interest will decrease by 1 contract if a buyer is closing an old short position and the seller is closing an old long position. And open interest will stay the same if:

• A buyer is entering a new long position while the seller is simultaneously closing an old one, or,
• A seller is establishing a new short but the buyer is simultaneously closing an old position.

One way to use open interest to analyze sentiment on individual stocks is to examine the "open interest configuration" using front-month option data. The open interest configuration of a stock is simply the number of open puts or calls at the various strike prices and can be illustrated by plotting a chart with adjacent call and put bars representing the open interest at every strike price. This approach has proven effective in determining possible resistance and support levels. How?

Option strike prices are usually round-number levels that tend to serve as support or resistance, as buyers view pullbacks to such levels as good entry points for long positions or potential closeout points for short positions. Sellers, on the other hand, look to rallies to round numbers as opportunities to exit long positions or to establish short positions. The fact that there may be significant option open interest at strike prices corresponding to these round-number price levels serves to accentuate their significance as support and resistance.

Often times, you will see us reference how out-of-the-money peak call open interest can act as resistance and out-of-the-money peak put open interest can provide support for a stock. Here is an examination of why and how open interest can act as support or resistance.

There are 3 reasons peak (or heavy) out-of-the-money call open interest can act as resistance:

• A large accumulation of call open interest can define a point of extreme market optimism, which usually coincides with the depletion of buying strength. When this strength is gone, it takes less selling activity to change the stock's direction.
• Those investors that sold these options may buy the underlying stock to balance their bearish position from selling the options. These long positions will ultimately be sold when the options expire or the call buyers unwind their positions.
• Finally, call sellers that don't hedge their position will try to pressure the market as it approaches the strike that the calls were sold in order to protect themselves from losses.

Let's take a look at the 3 reasons that peak (or heavy) out-of-the-money put open interest can provide support:

• A large accumulation of put open interest can define a point of extreme market pessimism, which usually coincides with the depletion of selling strength. When this strength is gone, it takes less buying activity to change the stock's direction.
• Those investors that sold these options may short the underlying stock to balance their bullish position from selling the options. These short positions will ultimately be bought back when the options expire or the put buyers unwind their positions.
• Finally, put sellers that do not hedge their position will try to support the market as it approaches the strike that they sold in order to protect themselves from losses.