The traders who are trading in F&O Space must be familiar with this term,But many novice traders might not be having full knowledge and the benefits of Open Interest.I have compiled this article to have more clarity on OI and its use in trading.
What is Open Interest?
Open Interest is the total number of outstanding contracts that are held by market participants at the end of the day.
It can also be defined as the total number of futures contracts or option contracts that have not yet been exercised (squared off), expired, or fulfilled by delivery.
Open interest applies primarily to the futures market. Open interest, or the total number of open contracts on a security, is often used to confirm trends and trend reversals for futures and options contracts.
Open interest measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract.
The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number.
Eg. It refers to the contracts outstanding on a particular day. Suppose the open interest in Nifty June 5000 calls is 64.5 Lakh contracts. This means that 64.5 Lakh contracts are due for delivery on expiration of the option on the last Thursday of the month.
How to calculate Open Interest?
Each trade completed on the exchange has an impact upon the level of open interest for that day.
- If both parties to the trade are initiating a new position (one new buyer and one new seller), open interest will increase by one contract.
- If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract.
- The third and final possibility is one old trader passing off his position to a new trader (one old buyer sells to one new buyer). In this case the open interest will not change.
Examples for the above scenarios:
- If trader X buys 2 futures contract from trader Y(who is the seller), then open interest rises by 2.
- If another trader A buys 2 futures contracts from trader B, then the open interest rises to 4. Now, if trader X unwinds his position and the counter party is either Y or B, then the open interest in the system will reduce by that quantity.
- But if X unwinds his position, and the counter party is a new entrant, say C, then the open interest will remain unchanged. This is because while X has squared off his position, C’s position is still open. The level of outstanding positions in the derivatives segment is one of the parameters widely tracked by the market.
Benefits of monitoring open interest?
By monitoring the changes in the open interest figures at the end of each trading day, some conclusions about the day’s activity can be drawn.
Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend (up, down or sideways) will continue.
Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. A knowledge of open interest can prove useful toward the end of major market moves.
A leveling off of open interest following a sustained price advance is often an early warning of the end to an up trending or bull market.
Open Interest – A confirming indicator?
An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.
The relationship between the prevailing price trend and open interest can be summarized by the following table.
Market is Strong
Market is Weakening
Market is Weak
Market is strengthening for bears
- On Monday, if Nifty futures closes at 5000 and S&P Nifty at 5025, then it is said Nifty futures are trading at a 25-point discount to the cash market index. Let’s assume that open interest in the Nifty futures contract on Monday was 1 crores units. Now, on Tuesday, if Nifty futures closes at 5050, S&P Nifty at 5060 (discount reduces to 10 points) and open interest rises to 1.25 crore, then it means, investors have created long positions.
- If open interest in the contract rises, but price falls, then it indicates that investors are cautious or bearish. In short, investors are creating short positions.
- In case open interest in the futures contract falls, but its price moves up, it indicates a bullish trend. This situation is a result of covering of short positions.
- Where there is a fall in open interest and price too, analysts read it as a bearish signal, as investors are liquidating their long positions .
The above example can be used in these scenarios too. In the options segment, a change in open interest in put or call options enables traders calculate the put call ratio chart (PCR) — a popular sentiment indicators of options traders worldwide, which is the number of puts divided by the number of calls.