What is Open Interest…….?
It can also be defined as the total number of futures contracts or option contracts that have not yet been exercised (squared off), expired, or fulfilled by delivery.
Open interest applies primarily to the futures market. Open interest, or the total number of open contracts on a security, is often used to confirm trends and trend reversals for futures and options contracts.
Open interest measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract.
Therefore, to determine the total open interest for any given market we need only to know the totals from one side or the other, buyers or sellers, not the sum of both.
The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number.
How to calculate Open Interest..?
Each trade completed on the exchange has an impact upon the level of open interest for that day.
For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract.
If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract.
The third and final possibility is one old trader passing off his position to a new trader ( one old buyer sells to one new buyer). In this case the open interest will not change.
Benefits of monitoring open interest…?
Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend ( up, down or sideways) will continue.
Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. A knowledge of open interest can prove useful toward the end of major market moves.
A leveling off of open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.
Open Interest – A confirming indicator..?
An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.
The relationship between the prevailing price trend and open interest can be summarized by the following table.
Price Open Interest Interpretation
Rising Rising Market is Strong
Rising Falling Market is Weakening
Falling Rising Market is Weak
Falling Falling Market is Strengthening
a specific underlying security, and
that have identical terms.
That is, the total contracts for a specific strike price and expiration date, that have been traded, but have not yet expired, have not yet been closed through a closing transaction, or have not yet been terminated via early exercise. A closing transaction occurs when a counterparty that is long the contract sells, or, conversely, when a counterparty that is short the contract buys.
Open interest is normally used as an indicator with a security but it can also be used with other instruments such as a currency.
For the IBM call option struck at 90 and expiring in January 2007, the total open interest on February 10, 2006 was 10251.
Option traders use open interest as an indication of how actively traded the options in an underlying security may be. For instance, if open interest increases suddenly from one day to the next, it's likely that new information about the underlying security has been revealed, which may indicate a near-term rise in the underlier's volatility. Based on studies carried out in international exchanges,it is found that open interest is maximum near month expiry contracts.
Signals from open interest
It refers to the contracts outstanding on a particular day. Suppose the open interest in Satyam September 230 calls is 645 contracts. This means that 645 contracts are due for delivery on expiration of the option on the last Thursday of the month.
Open interest is different from volumes. Suppose you buy one contract of Satyam 230 calls from me, the open interest is one contract, as is the volume in that option.
Now, suppose you immediately sell the 230 calls to another person, the volumes will increase to two contracts. The open interest, however, remains at one! Why?
As you have sold an option that you bought earlier, you are out of the market, while another person has entered for the first time.
So, this new trader is long one contract, while I am still short one contract. Therefore, the open interest is only one contract.
Open interest can be used to read the sentiment in the stock concerned. How?
Observe the open-interest-to-volumes ratio. If this ratio is low but rising, it means that the volumes traded are higher than the open interest. This is an indication that traders are accumulating the option.
In such cases, the rise (change) in open interest over the previous day will be far higher than the rise (change) in volumes.
For instance, open interest may rise from 25 contracts to 100 contracts (300 per cent increase) while volumes may rise from 200 to 400 contracts (100 per cent increase).
Such a signal in a call option may well mean that the stock could move up.
If such a signal occurs in a put option, it may well mean that the stock could move down.
Open interest is the total number of outstanding futures and options (F&O ) contracts at any point in time. In other words, these are open or yet to be settled contracts. For instance, if trader X buys 2 futures contract from trader Y(who is the seller), then open interest rises by 2.
If another trader A buys 2 futures contracts from trader B, then the open interest rises to 4. Now, if trader X unwinds his position and the counter party is either Y or B, then the open interest in the system will reduce by that quantity.
But if X unwinds his position, and the counter party is a new entrant, say C, then the open interest will remain unchanged. This is because while X has squared off his position, C’s position is still open. The level of outstanding positions in the derivatives segment is one of the parameters widely tracked by the market.
How can one interpret open interest data?
While open interest shows the total number of outstanding contracts, the data is not much of use, if looked at on a standalone basis. In the futures segment, open interest data need to be read along with price changes in the futures contract.
A rise in open interest in a futures contract along with its price ind
icates bullishness, which means investors are creating long positions. Investors may benchmark the price changes in the futures contract to the underlying (the cash market).
For instance, on Monday, if Nifty futures closes at 3000 and S&P Nifty at 3025, then it is said Nifty futures are trading at a 25-point discount to the cash market index. Let’s assume that open interest in the Nifty futures contract on Monday was 1 crore units. Now, on Tuesday, if Nifty futures closes at 3050, S&P Nifty at 3060 (discount reduces to 10 points) and open interest rises to 1.25 crore, then it means, investors have created long positions.
The above example can be used in these scenarios too. In the options segment, a change in open interest in put or call options enables traders calculate the put call ratio (PCR) — a popular sentiment indicators of options traders worldwide, which is the number of puts divided by the number of calls.
Is open interest the same as trading volumes?
Open interest should not be mistaken for volumes, which is the total number of contracts that have been traded in a trading session. Higher the number of trades in a session, more will the volumes swell, unlike open interest, which drops if a contract is liquidated. Usually, traders use volumes data along with open interest data and prices to derive a more concrete view on the market.
Why do traders get nervous when open interest is higher-than-average , when the market is also at record highs?
Many experienced traders perceive an abnormally high open interest in a rising market as a warning that there could be a reversal in the bullish trend. This is because several of the weaker traders in the market, who had jumped on to the bandwagon when the market was rising , could square up positions at the slightest signs of correction, thereby sparking a self-feeding fall.