Skill Sheet: What You Will Learn Here
- Understand open interest
- Know how open interest is calculated
- Interpretation of open interest
- Learn how to do open interest analysis
In general, Open Interest (OI) can be interpreted as a barometer of the overall active money in a particular product. So what is Open Interest in the derivatives market? In the derivatives market, where futures and options are traded, open interest represents the total number of outstanding contracts which continue to be held by trading members at the end of each trading session.
It is important to note that the OI changes only when there is a new contract is introduced into the market and not when an existing contract changes hands. This means that the OI increases only when two parties, say buyer B1 and seller S1 enter into a new position. If B1 then sells this existing contract to another trading member, say B2, the OI remains unchanged because this does not represent the creation of a new position. Similarly, the OI decreases only when a position in the market is closed and remains unchanged in case an existing contract is simply traded with another member.
While volume and OI are closely linked, there is an important distinction to be made between the two. Volume measures the number of all contracts that have been traded in the markets, while OI will reflect only the number of outstanding contracts. As a result, the volume numbers will include any trades of existing contracts in the markets as well. OI, on the other hand, changes only when new buyer-seller relations are created in the markets through their entry into fresh derivative positions.
When looking at OI numbers, an important perspective is to remember that it represents the fresh inflow or outflow of funds into or from the markets. In simple words, when OI increases, it represents the creation of new positions and hence, new money flowing into the derivatives market and vice versa.
At times, trading members also prefer to look at the OI changes from the previous day in order to get a sense of the activity on a particular day. This is helpful because the OI figures are cumulative and add up over the time life cycle of a derivative contract. For example, if there are already 100 outstanding contracts in the market and only 1 new position is created in today’s trading session, the number of overall outstanding contracts will go up to 101 but it might be helpful to note that only 1 fresh position was created in the current session. As a result, OI change might help in understanding the recent moves in the markets.
Open Interest Analysis
Now let's look at what is open interest options data and how to interpret it. In the derivatives market, OI is an important metric as it has multiple interpretations and uses. In general, analysts use the OI most commonly for determining the strength of a trend in the markets. Several traders use OI, along with technical analysis tools, to check for trend strengths and reversals.
Specifically, a market move in either direction, up or down, accompanied by a large OI buildup, is seen as a sign of a strengthening trend. This is because a situation where there has been a large movement shows the existence of a certain sentiment in the market. Further, when this is accompanied by increasing OI, one might infer that fresh money is also flowing into the markets to support this sentiment further. As a result, such trends might continue and strengthen in the coming sessions.
On the other hand, decreasing OI is taken as a sign of trend reversal. As a trend, whether up or down, progresses, OI decreases can be interpreted as an outflow of money from the market. As a result, there might not be enough money in the market to continue to support the trend and hence, it might reverse in the coming sessions.
Short buildup takes place when the OI increases with a decrease in the price. This indicates that new contracts have been created and more traders have bearish views or believe that the price won’t go past a certain level. Short covering takes place when traders decide to close their short positions. When the price increases with a decrease in the open interest, short covering takes place. Short covering leads to an increase in the price of the underlying.
When the open interest is rising along with the rise in price, it means more trades are on the long side and a long buildup is taking place. When both open interest and price are declining, it is believed that longs are covering their positions, also called long unwinding.
The OI data for options on the National Stock Exchange is available on the Option Chain, which can be accessed on this link. Note that the OI for the call options is different from that of the put options due to the fact that these are two different derivative products and hence, have their independent contracts. The Option Chain also gives information about the change in OI, and this can be used by traders to understand recent market movements.
Additionally, OI change can also be used to determine the support and resistance zones in the market. This line of argument relies on the assumption that option sellers represent the “smart money” in the markets and hence, might act as an important source of market movements. Based on this understanding, large OI buildups at a level indicating that the option writers do not foresee the market moving beyond those levels and hence, sell contracts at that particular level.
For example, in the above Option Chain, it is evident that there is a lot of OI (89,974 contracts) in the call options with a Strike Price of 16,800. This means that the people who have sold these options will start to lose money in case the NIFTY goes above the 16,800 mark. As a result, some traders take this as a resistance level because the option sellers, who usually happen to be institutional investors and traders, do not foresee the markets crossing this level on the upside. It is because of this very reason that the OI at important psychological levels is almost always very high. In the above Option Chain, for example, one can see that there is a lot of OI in the call option with a 17,000 strike price (1.19 lakh contracts). Similarly, the OI in the call option with a 16,500 strike price is also quite high at 1.46 lakh contracts.
Points to remember:
- Open Interest represents the total number of outstanding contracts.
- OI Changes only when a new contract is formed.
- OI analysis can help in figuring out the strength of a trend.