What is open interest and how can we profit from it? As you know, the more tools you have, the more opportunities you have in different market environments. Let's start by defining open interest: open interest is the total amount of contracts held by buyers or short sellers at a given time on an option or futures contract. Open interest goes up and down when new contracts are created by buyers and sellers. On the other hand, open interest falls when both the option buyer and seller close out their positions and the contract disappears. Keep in mind that open interest only changes when new contracts are created. For instance, when a bullish trader sells his calls to another bullish trader, open interest remains the same because a new contract is not created.

Today we will talk about options on major ETF's like the SPY's and the QQQQ's, and also options on large cap stocks like Microsoft and Google. First, let's look at options on major indices such as the QQQQ, and SPY. Options on these securities are often used as hedges. Believe it or not, open interest often changes according to seasonality and according to the calendar on some securities. This is due to large hedging positions that certain institutions use. For example, many tech-heavy portfolio managers buy QQQQ's puts at the beginning of each quarter for hedging. The same goes for SPY's.

Open interest tells you about the battle between bears and bulls and it's important to take a note of changes in open interest in the midst of rises and falls in the underlying security. When open interest goes up for calls, this is a bullish sign when you are in a bull trend. The opposite goes for puts. Watch trends closely because if open interest rises for calls during a bull trend in the stock, it's likely that the bullish trend will continue. However, if open interest begins to decrease, it's likely that a trend will end soon. Also, if the rise in open interest stops during a bull trend, it tells you that a trend is starting to weaken and may reverse soon.

Rules to Profit From (QQQQ's,SPY's, and other securities used for hedging)

Here are some rules you can use that apply to call options. You can reverse them and use them on puts as well. When open interest increases on calls during a bull trend, the uptrend is confirmed, and it often a green light to add new call positions. When open interest rises during a bear trend, it means that a lot of value-buying is occuring and it may be a great time to buy puts because many of the value buyers may force stock prices down as they bail out of their losing bullish positions. If open interest rises on puts while the underlying security is in a trading range, this is often a bearish sign. This means that savvy institutions are likely to sell short at least in the short-term. 

Rules to Profit from Stock Options

The rules on stock options are different because most options on stocks are used for speculation rather than hedging. Because of this speculation, most option buyers are wrong. They often buy puts as stocks go through powerful bull trends, and they buy calls when they are in powerful bear trends. Ultimately, you will notice that option buyers switch their sentiment from calls to puts or vice versa at exactly the wrong times. Follow these rules to gather profits: When a stock is in a powerful bull trend, and the put to call ratio on the stock remains steady or increases, put buyers are non-believers in the trend. It is likely that the trend will continue. When the put/call ratio on a stock suddenly changes in powerfully trending stocks, the trend is likely to reverse. This change in the put/call ratio indicates that the trend is probably weakening. Use these contrarian tools to profit from open interest and equity put to call ratios today.

Price Headley is the founder and chief analyst of BigTrends.com.