Buying and selling options is just like buying and selling stock - almost.
They are traded via a broker, have bid and ask prices and market depth, just like stocks do. As a matter of fact with some electronic platforms, you won’t notice any difference.
If you want to buy or sell common stock, you just go into the market and place your order. There is a set number of shares outstanding, issued by the company that never changes unless by corporate action.
Options are different in that the company the option pertains to do not issue them; traders create them out of thin air. This is where the term “Open Interest” is applicable, which I mentioned in the last section, more on that in a moment.
When placing a trade, it is important to tell the broker whether the order is to open or close a trade. If for instance you want to buy 10 INTC May $20 call options that you do not yet own, you would say “buy to open 10 x INTC May $20 call options at x price”. If you wanted to sell those options before expiry, you would tell the broker “sell to close 10 x INTC May $20 call options at x price”.
Similarly if you were going the write the above options, you would say, “Sell to open 10 x INTC May $20 call options at x price”. If you wanted to buy back those options before expiry, you would tell the broker “buy to close 10 x INTC May $20 call options at x price”.
Some electronic platforms will know whether the order is to open a position or to close a position automatically.
This brings me at last to open interest. Open interest is simply the number of open contracts in existence at that point in time. If an option has 0 open interest there are no open contracts. For there to be an increase in the open interest, there must be opening orders on each side of the trade.
For instance in the example above where we bought to open 10 INTC call options, the person selling you those options would have to be selling to open for there to be an increase by 10 in the open interest. That means that there are 10 new call option contracts that have been created in that series.
Likewise, for the open interest to decrease, both sides must be closing orders. For instance in the example above where we sold to close 10 INTC call options, the person buying those options would have to be buying to close for there to be decrease by 10 in the open interest. That means that there are 10 call option contracts that have been closed out in that series.
If however one side of the trade were an opening transaction and the other side of the trade a closing transaction, there would be no effect on open interest.
Open interest is an effective indicator on the likely liquidity of a particular option series. The higher the open interest, obviously the higher the number of traders involved in that contract. This generally results in tighter bid/ask spreads.
By the process known as novation, the person you traded with when you opened a position does not have to be the person with which you close the position. It can be anybody who is in the market at that time. This ensures that you can readily trade out of any position that you may have open; you are not obliged to wait until expiry.
Next - More On Options Pricing