What is Open Interest?

PDF

In this article, we will discuss

• What is Open Interest?
• How Open Interest is Calculated?
• How to Use OI for Intraday Trading?
• Relationship Between Open Interest and Volume
• Importance of Open Interest in Options Trading
• Factors That Affect Open Interest
• Limitations of Open Interest as a Trading Indicator
• Conclusion

Open interest is key to understanding the unseen opportunities and risks in the share market. Open interest is like breadcrumbs left behind that reveal a hidden network of trades and signals what traders are plotting next. If you want an edge in the share market, make open interest your new best friend. Follow this blog to learn what open interest is, how open interest forms, what it tells you about market sentiment, and how to leverage it to your advantage. Let's dive into the concept of open interest and uncover how it impacts stock market prices.

What is Open Interest?

Open interest meaning is the total number of outstanding options and futures contracts that have not been settled, closed out or exercised. Simply put, it is the number of existing active positions in options and futures contracts. For example, OI increases by one if a buyer and a seller enter into a new call option contract. OI decreases by one if the same buyer and seller close their contract by taking an opposite position. If the buyer sells his contract to another buyer, OI remains unchanged, as there is no net change in open positions.

How Open Interest is Calculated?

OI is calculated by counting the number of open contracts at the end of each trading day. A contract opens when a buyer and a seller create a new position. A contract is considered closed when an existing position is offset by an opposite position or exercised.

For example, let us assume that four traders are in the market: A, B, C, and D. They trade Nifty futures contracts. Each contract represents 75 units of the Nifty index.

• On day 1, A buys 1 contract from B, who sells 1 contract to A. This creates a new contract in the market, and OI increases by 1.
• On day 2, C buys 2 contracts from D, who sells 2 contracts to C. This creates two new contracts in the market, and OI increases by 2.
• On day 3, A sells 1 contract to C, who buys 1 contract from A. This closes an existing contract in the market, and OI decreases by 1.
• On day 4, B buys 1 contract from D, who sells 1 contract to B. This closes another existing contract in the market, and OI decreases by 1.

The table below summarizes the transactions and OI changes:

How to Use OI for Intraday Trading?

OI can be used as an indicator of market sentiment and trends. Generally, increasing OI means new money flows into the market, indicating more interest and activity in the contract. This can signal a continuation of the current trend. Decreasing OI means that money is leaving the market, indicating less interest and activity in the contract. This can signal a reversal of the current trend.

For example, if Nifty futures are in an uptrend and open interest Nifty is increasing, more buyers are entering the market and pushing the price higher. This can be a bullish sign for intraday traders who want to go long on Nifty futures. On the other hand, if Nifty futures are in a downtrend and OI is decreasing, more sellers are exiting the market and pulling the price lower. This can be a bearish sign for intraday traders who want to go short on Nifty futures.

However, OI alone is not enough to determine the market direction. It should be used with other indicators such as price action, volume, and technical analysis. Sometimes, OI can increase or decrease without any significant change in price or volume. This can indicate a consolidation or indecision phase in the market. In such cases, intraday traders should wait for a clear breakout or breakdown before taking any position.

Relationship Between Open Interest and Volume

OI and volume can provide different insights into the market behavior and direction. The relationship between open interest and the volume of options is an important one to understand:

• Volume refers to the total number of option contracts traded during a specific period, usually daily. It measures trading activity for that option. Open interest refers to the total number of outstanding option contracts that have not been closed or exercised. It represents the number of contracts still held by investors.
• For open interest to increase, volume must be higher than the number of contracts that expire, are exercised or closed. This indicates new positions are being opened.
• However, volume can be high without a corresponding increase in open interest if most trades involve existing contract holders liquidating their positions or changing sides (sell to close and buy to open).
• Similarly, open interest can remain flat or decline even if the volume is high if the new trades mainly involve existing contract holders. The key is whether net new positions are being opened.
• Generally speaking, a rising trend in open interest and volume is the most bullish signal, as it shows accumulation by new buyers entering the market.
• Declining open interest alongside declining or flat volume suggests a lack of interest and weakens the option's position.
• Spikes in volume without a corresponding increase in open interest are often temporary and insignificant. They represent a short-term surge in liquidity rather than a sustained buildup of new positions.

Importance of Open Interest in Options Trading

Open interest is an important factor to consider when trading options. Here is some importance of open interest in the share market:

• Market Sentiment: Higher open interest in call options shows bullish sentiment, while higher put open interest indicates a bearish sentiment. Tracking changes in close calls and putting open interest over time can provide insights into shifts in market positioning.
• Strength of a Trend: Rising open interest in the direction of a stock's move confirms and strengthens a trend while declining open interest questions the sustainability of the move.
• Influences Option Prices: Higher option open interest tends to push option premiums higher as more participants compete for contracts. This makes options with higher open interest more expensive.
• Liquidity: Open interest is closely correlated with options liquidity. The more outstanding contracts there are, the more potential counterparties exist, making entering and exiting positions easier.
• Volatility: Higher NSE open interest tends to coincide with higher volatility as more traders are exposed to the underlying security's price fluctuations. This translates into wider bid-ask spreads.
• Signals Potential Supply and Demand: High open interest represents the potential supply of contracts should option holders decide to exit their positions. Conversely, low open interest means little potential buyer demand.
• Establishes a Baseline: Comparing current open interest to historical levels provides context for interpreting the significance of changes in new open interest. Spikes above or drops below the norm may be more meaningful.
• Impacts Exercise Risk: The higher the open interest, the greater the likelihood that option contracts will be exercised if they move deep into the money. This increases exercise risk for option writers.

Factors That Affect Open Interest

There are a few key factors that can affect the open interest of an options contract:

• Expectations of Price Movement: If traders expect the underlying stock price to move in a certain direction, they will buy more options contracts, increasing open interest. Conversely, if traders expect little price movement, open interest may decrease.
• Time to Expiration: Options closer to expiration tend to have a lower open interest as traders close out positions or allow contracts to expire. Options with more time left until expiration typically have a higher open interest.
• Contract Specifications:Certain strike prices, option types (call vs put), and contract sizes may be more popular among traders, resulting in higher open interest for those specific options.
• Recent News or Events:Big news about the underlying stock can suddenly drive up open interest as traders react and take positions based on the news.
• Options Activity: When major traders or institutions take large options positions, it can significantly increase open interest for those specific contracts.

Limitations of Open Interest as a Trading Indicator

Open interest is the total number of open contracts on security. It is used as an indicator to determine market sentiment and the strength behind price trends. However, open interest has some limitations as a trading indicator. Some of them are:

• Open interest does not show the direction of the trend, only its intensity. It does not distinguish between long and short positions, only the total number of contracts.
• It is not updated in real-time but only at the end of each trading day. This means that the indicator does not reflect intraday changes in open interest.
• Open interest can be influenced by factors other than market sentiments, such as rollover, arbitrage, hedging, and expiration. These factors can cause open interest fluctuations unrelated to the underlying price trend.
• It can sometimes give false signals or contradict other indicators. For example, if open interest rises during an uptrend, it can indicate either new buying or short covering. Similarly, if open interest falls during a downtrend, it can indicate either long liquidation or new short selling.

Conclusion

In summary, open interest provides valuable insights into the behavior of an options or futures market. It indicates the total number of contracts not offset or liquidated by opposite trades. Combined with price and volume data, open interest can reveal whether a price move is due to panic buying or selling or a fundamentally driven shift in demand and supply. Open interest tracking is crucial for traders and investors looking to gauge market sentiment and position themselves accordingly. Together, price action, volume and open interest form a complete picture of what is occurring beneath the surface of any derivatives market.  

If you want to learn more about open interest and how to use it in your trading strategy, you can check out Samco’s website. Samco is a leading online broker that offers low brokerage fees, high leverage, and advanced trading platforms. You can also access Samco’s research reports, educational resources, and trading tools to enhance your trading skills and knowledge. To start trading with Samco today, click here and open your free account.