Definition
Open interest is the total amount of outstanding derivatives contracts.
In plain and simple English: the total amount of positions people still have open. This means both longs + shorts. Open interest is plotted as a continuous chart, usually in candlestick format, which often moves in tandem with price but not always.
When the open interest goes up it means people are opening new positions, when it goes down it means people are closing positions, sometimes forced closing in the form of a stop-loss or liquidation getting triggered. It's as simple as that.
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Calculating the amount of open contracts
Crypto derivatives markets are peer to peer, meaning that there's always someone on the other side of your trade. It's often another trader just like you, but it could also be a market maker. Whoever your counterparty is, there always needs to be a short for every long, because if you're buying someone else needs to be selling, otherwise the market just wouldn't work. With this in mind, let's check some examples of how open interest increases or decreases.
Trader A opens 2 long contracts, trader B opens 2 shorts: +2 OI, total = 2
Trader C opens 3 longs, trader B opens 3 more shorts: +3 OI, total = 5
Trader A opens 5 more longs, trader D opens 5 shorts: +5 OI, total = 10
Trader C closes 3 longs, trader D closes 3 shorts: -3 OI, total = 7
Remember, open interest is the total amount of outstanding contracts. If you open 1 long, to have a valid contract you need a counterparty that opens 1 short. That's how the market works, you need a sell for every buy. So 1 long + 1 short = 1 OI.
Another thing that you have to understand for this exercise:
A "long" is a buy, when a long closes it becomes a sell.
A "short" is a sell, when a short closes it becomes a buy.
Shorting feels less natural for most people and it's something, I've noticed, rookies get confused on.
Think about it this way: when you short you're selling coins that you borrowed and when you want to close the position you have to buy back what you sold and based on the price difference from where you sold and where you eventually bought back you either make or lose money. If the price where you have to buy back is lower than where you opened the position you obviously make money.
Now that we know this let's check a few more examples, continuing the previous exercise.
Trader A closes 5 old longs (sells), trader C opens 5 new longs (buys): +0 OI, total = 7
Trader B closes 3 old shorts (buys), trader D opens 3 new shorts (sells): +0 OI, total = 7
1 to 1
Although the long/short ratio is always 1 to 1, there's almost always one side that dominates in the sense that it has more risk-on directional traders. This happens because there are always market participants who are making a neutral trade, are hedging, or they're market makers. If you go long for example and your counterparty is market maker liquidity, then there's one extra directional long in the market and one neutral short. In this case we would say that "there are more longs than shorts", which technically isn't a correct statement of course. A better way to describe it would be: "open interest is currently dominated by long biased directional traders" which doesn't really roll of the tongue, that's why we usually just say that there are more longs or shorts.
Figuring out which side of the trade is dominated by these risk-on directional traders (speculators) can give you better insight in the state of the market and possibly make it easier to decide what type of trade you should be taking. But that topic will be for another post!
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