Particularly outside equity markets having a finite number of shares available, many traders ignore open interest records in their option trading strategies. Primarily this is due to the impossibility of differentiating whether the open interest …is long or short, and so whatever good that may result from this knowledge is immediately squandered.
Bearing in mind that option contracts have two methods of closing out; a trade offsetting the opening trade, and exercise of the option which will create a position in the underlying instrument. Both will lead to open interest being commensurately reduced.
When an option strike is traded and the open interest reduces, the fact that previous position holders have closed their positions is revealed. When traded to result in an increase in open interest, clearly, positions have been initiated. When no change exists this shows some parity between closing transactions and initiating transactions.
If a particular option strike is traded with keen interest to such an extent that the open interest in that option strike suffers a marked increase, the trader will be able to deduce that a large participant or participants are initiating positions. This could be indicative of the direction that underlying market is about to take, or it may merely be a hedge against a position in a remotely connected external market.
Still the rapid increase in open positions while not particularly concerning to the majority of traders, will be borne in mind by the astute in order to take advantage of others favored positions.
When the rest of the market has absorbed the counter position to one particular initiating trade, they will be keen to close that position out and redistribute value across other option strikes. Particularly when this creates a large open position record, it necessarily creates a secondary market in the option strike at hand.
By virtue of a secondary market depicted by open interest, liquidity in that option strike is now made inherently stronger. This in turn has consequences for the entire option market and every strike price therein. When liquidity abounds the bid/ask spread for that strike price will narrow due to competition within the market place. As attempts to crystallize profits are made, traders will seek to redistribute value and s doing increased competition will arise in adjoining strike prices.
The wary trader will use this information as part of his options trading strategy to preempt the existence of latent over supply or over demand of particular strike prices. Indeed, if these anomalies are public knowledge a natural skew will develop in the market quite aside from probability and its mathematical deduction.