Open interest is an important factor that investors should observe when trading in options. What is open interest?

It refers to the contracts outstanding on a particular day. Suppose  the open interest in Satyam September 230 calls is 645 contracts.

This means that 645 contracts are due for delivery on expiration of the option on the last Thursday of the month.

Open interest is different from volumes. Suppose you buy one contract of Satyam 230 call from me, the open interest is one contract, as is the volume in that option.

Now, suppose you immediately sell the 230 calls to another person,the volumes will increase to two contracts. The open interest,however, remains at one! Why?

As you have sold an option that you bought earlier, you are out of the market, while another person has entered for the first time.

So, this new trader is long one contract, while I am still short one contract. Therefore, the open interest is only one contract. Open interest can be used to read the sentiment in the stock concerned. How?

Observe the open-interest-to-volumes ratio. If this ratio is low but rising, it means that the volumes traded are higher than the open interest. This is an indication that traders are accumulating the option.

In such cases, the rise (change) in open interest over the previous day will be far higher than the rise (change) in volumes.

For instance, open interest may rise from 25 contracts to 100 contracts (300 per cent increase) while volumes may rise from 200 to 400 contracts (100 per cent increase).

Such a signal in a call option may well mean that the stock could move up.

If such a signal occurs in a put option, it may well mean that the stock could move down.