Open Interest (OI) Analysis of Futures and Options

In the previous chapter, we learnt about hedging and how it helps in protecting you from running into losses. In this chapter, we are determined to enhance your knowledge further. Let us understand Open Interest which is essential for having better trading sessions and profits.

Open interest is the total of outstanding derivative contracts which are not settled for an asset. Open interest is typically associated with futures and options. Let us understand what contacts are and how contracts are created for futures and options. For creating a Futures and Options contract, there must be a buyer and seller who chose to adhere to the contract. A contract is equal to a hundred shares of underlying assets. A contract remains open until the counterparty chooses to close it. 

You must keep in mind some important points about open interest:

• Open interest is the total number of contracts which are bought or sold.
• When the contacts are added, the open interest increases. And when the contracts are squared off, the open interest decreases.
• With the increase in open interest, the money inflows into the market. And with the decrease in open interest, the money liquidates or outflows.
• The measurement of market’s activity is open interest as it measures the flow of money in the market.

Two sides of trading are buying and selling of contracts. In comparing the open interest with the volume-

•   Open interest means the contracts which are open and live.
•   Volume refers to the number of trades which executes on a given day.

You must note that the change in open interest doesn’t conclude any directional view on the markets. Since the open interest is data which is continuous and cumulative, you must keep a check on incidences where the open interest indicates high leverage which is not normal.

Now let us take an example to understand the open interest. Let us say that  Rajesh, Mohit and Praveen are trading a similar futures contract. Now, Rajesh purchases two contracts to enter a long trade which increases the open interest by two. Mohit also decides to go long and purchases six contracts and increases the open interest to eight. If Praveen also decides to short the market and sells two contracts then the open interest again increases to ten.

Concept of Open Interest data in F&O

The main key aspects which the analysts and traders often look at is the Open Interest (OI) data. All positions which are still open refers to OI. To understand this better, let us have a look at an example:

Scenario 1: Rajesh bought 1 lot of Nifty Futures. Ravi sold 1 lot of Nifty Futures. Here, the market OI in Nifty is 1 lot. Now Rajesh and Ravi decide to reverse their positions which will bring down the OI of the Nifty to 0.

Scenario 2: Rajesh bought 1 lot of Nifty Futures, and Ravi sell 1 lot of futures. This creates a market OI of 1 lot. Rajesh sold his lot to Mohit on the next day. In this case, the Nifty remains at 1 lot because the party has changed and not the lot.

Scenario 3: Rajesh bought 1 lot of Nifty Futures and sold 1 lot. At the same Ravi bought 1 lot of Nifty futures and Mohit sold 1 lot. In the same manner, Praveen bought 8 lots of Nifty Futures and Sushma sold her 8 lots. In these entire activities, \the total OI of the Nifty Futures remain same which is 10 lots.

In these scenarios, we have understood the steps which are taken for creating and reducing the open interest concerning futures.

We can say that the OI of the Nifty contract will expand with new participants who will initiate new positions in the Nifty.

OI’s indication to a trader

For the traders and investors who want to take positions in equities uses OI shift because it gives some useful clues. The OI shifts can provide some interesting clues for the traders and even investors who are looking to take positions in equities.

Some essential indications are:

•   There is an increase in the OI of the stock when the interest builds up in the stock. The ownership widens, and more fresh investors take a position in the stock.
•   There is a decrease in the OI when the stocks which had a right rally can indicate that the rally is about to end.

The data which OI provides helps identify turnaround points in time. To be able to determine when the trend is changing allows investors and traders in making profits. You can get a couple of clear signals in many cases. When the stocks bottom out, a mix of fresh OI build-up happens with the institutional build-up of more prominent OI. 

In the case of MFs and FIIs, when the exchanges report total accumulation figures, we get an important clue about the turnaround. The opposite of this is also applicable if you are identifying reversal at the top.

Comparison between OI data and the stock price

In case you are comparing the nature of OI movement and the medium-term price trend, you will receive a better idea of the stock. And this is the best use of OI data. Following are some essential points to understand the usage of OI data for the stock price:

1. It can take it as a healthy sign if the Open Interest of the stock rises and the price also rises consistently.
2. It is a sign that investors are getting interested in the stock, and there is also the distribution of ownership that is happening. This is a crucial data point that helps traders and investors to judge the sustainability of a stock rally.
3. In case the stock is falling, but the price is rising then this is a sign that the market is weakening.
4. When the shorts are stuck in the position and book losses, then it is a case of short covering. In this case, the stock prices will be correcting once the short covering is over.
5. When the price is falling, but the OI is rising, it is not considered as a good sign. It indicates that fresh short positions are building up, which means that market expectations of the stock are negative. This is regarded as a sign of weakness because shorting happens in the case where traders are expecting a deep correction in the markets.

When the OI is falling, and the price is also falling, we can have two interpretations. The first is that long positions are unwinding and which indicates tension in the markets. However, secondly, it also shows that the stock will become light with regards to F&O leverage.  The cash market investors consider this as a positive signal.

We can say that OI is a crucial market indicator which, when compared with price movements, can provide some exciting market clues.

Wrapping up

Now that you understand reading futures and using Things to do with futures: hedging, it’s only logical that we move on to the next big topic - Trading index futures. To discover the answer, head to the next chapter.

A Quick Recap

• Open interest is the total number of outstanding derivative contracts, such as options or futures that have not been settled.
• A contract is equal to a hundred shares of underlying assets. A contract remains open until the counterparty chooses to close it.
• Increasing open interest represents new or additional money coming into the market while decreasing open interest indicates money flowing out of the market.