Open Interest in Trading Explained | Espresso

What is Open Interest in Trading?

There are two ways of investing in the stock markets – investing in the cash segment and investing in the derivatives segment. Most rookie investors prefer to invest in the cash segment through equity shares and mutual funds.

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However, a seasoned investor may wish to invest in the derivatives segment as it provides them with an opportunity to make comparatively high profits with lesser investments.

The most common way to invest in the derivatives segment is trading in Futures and Options (F&O). These two stock market derivative instruments allow you to make money through hedging against the asset classes and speculating the market movements. However, it’s also true that trading in F&O is risky. You need to have a fair idea of the market, and your speculations must be accurate. Or else, you could lose all your money.

There are many market tools and indicators that you can use to analyse market situations and predict short-term market movements. One such crucial indicator is “Open Interest”. Continue reading to know the open interest meaning and how it can help you in your F&O trading.

What is Open Interest?

Open interest in Futures and Options refers to the total number of outstanding F&O contracts that have not been settled for an asset at a given point in time. In other words, open interest in trading is the total number of active Futures and Options contracts on the stock exchanges. This indicator is used to know the demand for a security in the market and hence, speculate its short-term price movement.

The open interest for a security increases or decreases as per the prevailing market conditions. When the demand for new contracts rises in the market and an increasing number of investors start to buy them, the open interest rises. Similarly, when the demand for the security falls in the market, investors start to close their active F&O positions by selling their contracts. And hence, the open interest decreases.

How is Open Interest calculated?

To calculate the open interest, first, you need to add all active F&O contracts associated with the opening of new trades. And then, you can subtract all contracts associated with the closing of trades. Keep the following pointers in mind:

  • If a buyer and the seller both take up a new contract, the open interest rises by 1
  • If a buyer and seller both exit their positions, the open interest falls by 1
  • If a buyer or seller passes their current positions to a new buyer or seller, the open interest remains unchanged

Let’s understand the calculation of the open interest with the help of an example. Assuming that there are three different traders – A, B, and C – trading in Nifty50 F&O contracts, let’s calculate its open interest at a given point.

Suppose A buys six contracts, B buys four contracts, and C sells 10 contracts. Now, there are 10 active Nifty50 F&O contracts on the long side (A+B) and 10 active contracts on the short side (C); hence the open interest would be 10, i.e., the maximum number of active contracts at a given point.

Importance of the Open Interest

As mentioned, the open interest is a useful indicator that can be used to know the demand for security in the market and hence, speculate its short-term price movements. The open interest in trading also reflects the overall liquidity and market activity regarding a particular security. It also indicates the current mood and sentiments of investors.

A higher number of open interest indicates that more buyers and/or sellers are interested in buying or selling a particular security. If there is a high open interest for call options of a particular stock, it means that most investors are predicting that the price of that stock may go up. Similarly, if there is a high open interest for put options of a stock, it means that maximum investors are predicting that the price of that stock may go down.

In contradiction to all this, the lower values of open interest for F&O contracts of a stock indicate that investors are not interested in taking new positions in that stock at the given point in time. When the open interest for security is increasing, it indicates that the additional money is being invested in the market. And when open interest is decreasing, it means that money is being flown away from the market.

Conclusion

By investing in derivative instruments, you can make very good returns with comparatively small investments. However, it’s crucial to be aware of the risks associated with them and make diligent moves. You should have apt knowledge of the market, and you should know how to analyse the market using various indicators.
Also Read: How to analyse the Market trends?

Open Interest or OI can be a useful indicator for market analysis. Open interest analysis is typically done along with a ‘Volume’ indicator, which reflects the total number of F&O contracts traded during a given period. Volume is also a strong indicator that can show how actively a security was traded during the given market hours.

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Frequently Asked Questions

Open interest in trading can be a useful indicator to know the current mood and sentiments of market investors. You can use the OI along with the volume indicator in your market analysis charts to analyse the prevailing market situation and predict short-term price movements.

Although both open interest and volume indicators are used together, they are very different from each other. While the open interest indicates the total number of active F&O contracts in the market at a given point in time, the volume indicator reflects how many trades were executed during the given market hours.

Although open interest is a useful market indicator, it is not updated very frequently like the volume indicator. Open interests are usually updated only once every trading day. It’s because the open interest is calculated based on a broader metric spectrum rather than the instant or dynamic changes.