Skill Takeaways: What you will learn in this chapter
- What is open interest?
- The difference between open interest and volume
- What does OI indicate?
- Market Wide Position Limit and ban period
If you want to buy a stock in the spot market, you place an order, and as soon as the seller sells the same at a price mutually agreed upon, the transaction is closed. Subsequent actions like making payment and receiving the stock in your demat account take place as a normal practice. The transaction comes to an end as soon as the purchase and sale price/quantity are matched. However, if the buy order is not executed during the trading session, it will automatically get cancelled at the end of the session, and you will have to place a fresh order for the same in the next trading session.
However, derivative markets function in a slightly different manner. If you buy an option, for example, in the derivatives market, it will be considered an open transaction and will remain in vogue until either you close the transaction by selling the option or on the expiration of the contract period. Thus, an Open Interest (OI), as the name itself suggests, is a contract which is not yet settled and is open. So, whenever you buy an option, it will be added to the OI and it will remain so till you square off your position. But remember, every option buy contract will have a corresponding sell transaction too, and therefore, the buy and the corresponding sell together will be considered one OI.
OI & Volume
Now the question arises — is OI is same as Volume? Though they may appear to be the same, they are not. While volume takes into account all transactions – both settled and open – OI considers only those contracts that are not yet settled and are still open. Volume increases whenever a trade is opened or closed, but an OI number gets reduced as soon as a trade is settled or closed.
Further, volume is a daily figure, meaning at the beginning of the session, it always starts with zero, while OI is the continuation of the previous session. But as the trading session progresses during the day, the volume figure may overtake the OI figure, which, in case happens, indicates a high level of trading during the day.
However, the lack of bifurcation of OI with reference to different classes of participants, like traders, investors, institutions, etc., may, to an extent, lessen the utility of this information. Nevertheless, it is still considered an important tool in the hands of analysts while determining the future trend.
|Date||MWPL||NSE Open Interest|
Given above is the table showing OI in Reliance Industries between July 27, 2022, and August 4, 2022. July 28 was the expiry date for the July series, and you can see a build-up of OI on the eve of expiry and a drastic reduction of OI on expiry day. It may be noted that on the expiry date, OI doesn’t become zero, even if the option premium becomes zero, as many options buyers don’t find it worthwhile to square off their positions.
OI & MWPL
Along with OI, another column above provides the details of MWPL, meaning Market Wide Position Limit. Thus, the maximum number of OI in any stock is subject to this MWPL, which specifies the maximum number of contracts that can be open at any time. If the OI of any stock crosses 95% of MWPL (both, futures and options (F&O) included) the exchange will bar any fresh positions of F&O contracts in that stock. However, if you are already holding any position in the stock, you will be allowed to exit the existing positions during this period. Fresh positions will be banned till the OI falls below 80% of MWPL. During that period, stocks are said to be in the ‘ban period.’ This limit is fixed to avoid over-trading in a particular stock.
Further, exchanges also fix the maximum limit for gross open position across all F&O contracts on a particular underlying security for each specific client, FPI (Category III) or schemes of mutual funds.
Traders usually use OI information to predict the price range within which a stock price may move during the day. The stock price may find support at the strike price where the maximum number of OI is found on the put side. Also, it may find resistance where the maximum number of OI is found on the call side.
The concept of OI is very significant in reading the derivatives market as it helps analyse the direction of the market. So, the OI may be increasing or decreasing – when it is increasing, it indicates that more and more traders/investors are believing in the trend and are participating in the same. On the other hand, decreasing OI indicates that investors/traders are losing faith in the prevailing trend and are, therefore, withdrawing. However, high OI may not necessarily indicate a bullish or bearish trend always. But, usually, an increasing OI may suggest a continuation of the prevailing trend – upward, downward or sideways – as it shows new money is coming in. On the other hand, decreasing OI may indicate changing sentiment of the traders, which may eventually lead to a change in the trend. OI may start declining when short sellers cover their positions, and it may lead to a rally in the underlying’s price. But one should not arrive at a conclusion solely on the basis of the OI position.
In order to analyse the OI, it should always be compared with the past figures, and the change should be substantial to draw your attention. What is ‘substantial’ is an attribute which you may be able to develop over a period of time through experience.
Therefore, before taking a plunge in any stock option, it’s always prudent to verify the OI position to understand the liquidity of the option. When an option has a significant OI position, it shows that a large number of buyers and sellers have already taken positions in the option making it liquid.
Things to remember
- The buy and the corresponding sell together will be considered one OI.
- Volume takes into account all transactions – both settled and open – OI considers only those contracts that are not yet settled and are still open. Volume increases whenever a trade is opened or closed, but the OI number gets reduced as soon as a trade is settled or closed.
- Volume is a daily figure. So, at the beginning of the session, it starts with zero and increases thereafter. OI is the continuation of the previous session and it may increase or decrease based on new contracts being opened or old contracts being closed.
- Increasing OI indicates that more and more traders/investors are believing in the trend and are participating in it. Decreasing OI indicates that investors/traders are losing faith in the prevailing trend, and so, are withdrawing.
- So, before taking up a position in any option, it is best to take a look at the OI to understand the liquidity in the option.