Using Open Interest To Find Bull/Bear Signals

Many traders have been asking me question on my write up of FII Data analysis, Keeping all the question in mind i have prepared a cheat sheet which will help you in understanding my data analysis with more clarity.

1. What do you mean by Open Interest (OI) in futures and options? 

When there is trade between a buyer and seller, a contract opens and all such open contracts are together called as open interest. So if Trader A have bought 1 lot of Nifty Futures  expecting it to go up and Trader B have sold 1 lot expecting it to go down, that makes it 1 open contract and hence the open interest of 1.

2. How would you read  when I write  “Nifty futures went down with a huge addition of OI?” 

OI will go up when more people start participating or existing people start adding positions. According to the OI theory, typically when a market is going in a particular direction and there is a huge addition in OI, this means there is more conviction in the move.
So if the market is falling and there is a huge addition in OI, this would mean that the existing short positions which are making profits are adding more and hence the fall could be bigger. But understand that this is only theory and may or may not work like this in reality.

3. What would you infer when I write said “ Nifty 6200 CE OI  went up ” 

While trading options, the money required to buy options is much lesser than what is required to write (sell first). So typically the people who write options are people having access to higher capital and hence the logic is that they are more proficient traders.

I guess it is important to also understand why retail traders typically buy options and institutions sell them?

Coming back to the query, when OI for 8000 calls is going up, there are new buyers and sellers (writers) coming in and since the writer is a more proficient trader as explained above, the belief is that he is probably right and better be on his side of the trade which is basically expecting Nifty to not cross 8000.
So if someone says OI on Nifty 8000 calls has gone up significantly, according to the OI logic it means that if Nifty is above 8000 it might come below 8000 and if it is already below 8000, it might find it tough to go above 8000.

4. What would you infer if someone said “OI on Nifty 6000 puts went up significantly?” 

Similar to the explanation given above, since OI is going up on 7500 puts and because the option writer is more proficient generally, the belief would be that the market won’t probably go below 7500 and if it is already below 7500 it might bounce back above 7500.

5.  If I sell 2 lots and there are 2 people X and Y who have bought 1 lot each, assuming we are the only people trading the contract, the OI is 2. What happens if X who has bought 1 lot sells it to another person Z, what is the OI now?

When X sold the lot he had bought from you to Z, a new contract was not created; the existing contract just changed hands so the OI will remain two. But if Z bought say 1 lot from anyone other than X and Y, then that would be a new lot and hence the OI will now go to 3.
Since in the query above a new lot was not created, the OI remains at 2.

6. If the market is going down and OI is increasing market could go even lower because of the OI logic. But aren’t both the buyers and sellers increasing, why can’t we look at it like new buyers are coming in so the market might reverse?

Assume the OI is presently 10 on Nifty futures and Nifty is at 7600. This means there are 10 lots long and 10 lots short. The market came down to 7500, so the buyers together have a loss of 50,000 (10 x 75 lots = 750 Nifty x 100 points = 70,000) and the people who are short have a profit of the same.

At 7500, OI went up to 20, basically doubled. When OI went up, either the people who were holding positions from before added or new people came in and bought and sold lots. If you were looking at all of this, which side would you want to be on, long or short?

Understand that at 7600, longs are sitting at 75,000 loss and are weak and shorts are sitting on 75,000 profits and are stronger. The most important logic to make money in the market is to be with the trend, be with the person/stock who is stronger. That is why we infer that if OI went up significantly when market goes in a particular direction, the direction might continue for much longer.

7. Logic behind assuming that if the OI for 8000 calls went up significantly, markets might not cross 8000?

The whole theory of Open Interest conspiracy on options is based on the fact that the buyers of options are mostly retail who are probably not experienced and the sellers/writers are institutions who are more proficient and have been doing it for a while. So if you had to bet, be on the same side as the proficient one because the odds of winning go up.

So when the OI for 6200 calls is going up, there are new buyers and sellers coming in and since sellers are more proficient traders we assume that they are right and hence the market may not go above 6200.