OPEN INTEREST – CONCEPT AND PRACTICAL APPLICATION (Part-1)

In this article,

I will try to cover both theoretical and practical aspect of ‘OPEN INTEREST’ with answers to-

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A) What is OI in futures and options contracts?

B) What does OI reflect?

C) OI and Options

(I plan to cover the topic in 2 parts with this article being part-1)

What is Open interest?

For every seller of a futures or option contract, there must also be a buyer of the contract. OI is simply the measure of total open positions of a future or option contract. One seller and one buyer together create one contract.

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Therefore, the total open interest in the market for a specified futures or option market equals the total number of buyers or the total number of sellers, not the total of both added together.

(Meaning if there are 5 open positions in ABC security then the OI number would be 5)

The name itself says- OPEN ‘INTEREST’-referring to the interest shown by the market participants in a futures or options contract. The example in the previous line about ABC security tells us that the level of interest in the security equals to 5 contracts meaning there are 10 parties who are currently betting on this contract. (10 because the OI is not the total of both buyers and sellers but total of either buyers or sellers)

Its important to understand that an OI number will only change when there is increase or decrease in participation.

Lets understand this with another fun example like we always do.

You are unable to make up your mind about attending a party. So you dial your friend’s number who is present there to ask if the party is interesting or not.

Yeh-Jawaani-Hai-Deewani-Party-Song-HD

He tells you that when he arrived there were around 5 people present in the party but in the last 20 minutes 5 more have showed up which signifies that the level of ‘interest’ in the party is increasing.

You decide to wait for another hour and call your friend again. He tells you people are leaving and joining and since you both last talked around 6 people have left and 6 new have joined. This tells you that although new people have joined but the same number of people have left too which means the place is not getting filled enough to enjoy a real party.

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You are not concerned about who is leaving or joining. What you are concerned with is the NUMBER. The more the merrier after all. So, you decide to stay at home.


Similarly, what OI is concerned about is not the parties to contracts but the NUMBER. OI moves only when new a position in a derivative security opens or a previous one closes.

Look at this table and you will understand

Screenshot (322)


 

IMPORTANCE OF OI

  • Tells you about the liquidity in the security. Its obvious more the participation in a market, better the chances of executing your orders at good prices.
  • Open interest is a measure of the flow of money into a futures or options market. Increasing open interest represents new or additional money coming into the market, while decreasing open interest indicates money flowing out of the market.
  • Open interest is also used as a momentum indicator of trend strength. Since rising open interest represents additional money coming into a market, indicating increased interest in the market by investors, it is generally interpreted to be an indication that the existing market trend is gaining momentum and is likely to continue.
  • Conversely, decreasing open interest reflects declining interest on the part of investors and waning momentum, indicating that the existing trend may soon be exhausted, leading to a trend change
  • When compared with price it can result in multiple interpretations

 

GENERAL APPLICATION OF OI WITH FUTURES

Just like volumes any move in price which is accompanied with increase in OI is regarded strong and more reliable. Other ways of interpreting OI with futures-

  • PRICE UP with OI UP = FRESH LONGS
  • PRICE DOWN with OI UP = FRESH SHORTS
  • PRICE UP with OI DOWN = SHORT COVERING
  • PRICE DOWN with OI DOWN = LONG UNWINDING

OI AND OPTIONS

The things mentioned above are applied to both futures and options. But with options another dimension of analysis gets added which is very beneficial for short term traders especially for people trading indices.

The OI numbers can tell you where the supports and resistances lie and also about how likely they are to be breached

Suppose a guy named Peter tells you that he bought 50 lots of 11800 CE options and another guy named Rick tells you that he shorted (sold) 50 lots of 11800 CE options. Which out of the two will get your immediate attention?

two-people-talking-5a2d517b96f7d000375a5c1f.jpg

For people who trade in the F&O segment, Rick will definitely be the one who is likely to get their attention. Why? Because the money required to short 50 lots of Nifty CE is much more than the money required in simply buying them. (There will be another article for those who are not aware about this segment)

So you will be flowing with thoughts like-

”How much money this guy has in his account? What is so bearish in the market which made him do this?”

Also, whom do you think would have researched more before taking his position?

Well Most likely its Rick because if he is wrong his losses could theoretically be unlimited.

(These are the assumption which can be drawn by any rational thinker)

MORE MONEY INVOLVED=MORE RESEARCH INVOLVED

 

So in a way,

All participants in the short side of the bet-

  • Are Richer (The amount of money required to short options and risk involved can be absorbed by HNIs(high net worth individuals) and Institutions)
  • Have researched more (institutions have highly qualified professionals working for them and HNIs can hire the best advisors available)
  • Have better resources
  • Are less likely to panic unless things go too bad

Hmm….. So basically majority of the smart money is on the short side of the bet with option contracts.

Lets come back to the point of OI finding support and resistance areas.

If i tell you (as an example only) that right now the Highest open interest in nifty calls is at the 11800 Strike price and highest open interest in nifty puts is at 11500 strike price. What conclusion can you draw?

Remember smart money (with better resources) is on the short side of the bet.

Its right to think that till XYZ expiry the chances of Nifty remaining between 11500-11800 are much higher because that is what the smart money thinks.

In other words strongest nifty resistance is at 11800 and strongest support is at 11500

This means,

  • HIGHEST OPEN INTEREST AT AN OUT OF MONEY CALL OPTION STRIKE PRICE = MAJOR RESISTANCE ZONE FOR THE SERIES
  • HIGHEST OPEN INTEREST AT AN OUT OF MONEY PUT STRIKE PRICE = MAJOR SUPPORT ZONE FOR THE SERIES
  • SHIFT OF HIGHEST OI FROM AN OUT OF MONEY CALL STRIKE PRICE TO HIGHER STRIKE PRICES = BULLISH
  • SHIFT OF HIGHEST OI FROM AN OUT OF MONEY PUT STRIKE PRICE TO LOWER STRIKE PRICES = BEARISH
  • SHIFT OF HIGHEST OI IN BOTH OUT OF MONEY CALL OPTION STRIKE PRICE (TO HIGHER STRIKES) AND OUT OF MONEY PUT STRIKE PRICE (TO LOWER STRIKES) TOGETHER = MORE VOLATILITY EXPECTED DURING THE SERIES (WIDE RANGE)
  • SHIFT OF HIGHEST OI IN BOTH OUT OF MONEY CALL STRIKE PRICE (TO LOWER STRIKES) AND OUT OF MONEY PUT STRIKE PRICE (TO HIGHER STRIKES) TOGETHER = LESS VOLATILITY EXPECTED DURING THE SERIES (NARROW RANGE)

 

CONCLUSION

Open interest is a great indicator of strength and sentiment for futures and options traders.

In case of futures, it tells us that how the participants are using the moves in the market to take bets.(Are they adding more, booking profits, panicking etc)

In case of options, It tells us what is the range where the security is expected to move and what is the smart money expecting.

I hope this small article was helpful in understanding the concept behind interpreting OI in certain ways. I shall make a detailed video on other aspects of OI soon and another article exploring the relationship between open interest changes and option contracts.

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Thank you for reading.
By
Animesh Vashisht
Mob. +917906818121 (Whatsapp to be part of my broadcast list)

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