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Fundamentals Of Open Interest- Meaning & Interpretation



Open interest and its interpretation

Derivative instruments are traded based on contracts. A derivative contract is a standardized unit that derives its value from an underlying. In the cash market, even a single share can be bought and sold however in a derivative market a fixed number of shares are bunched together to form a lot. Therefore, in derivatives, lots of fixed predetermined numbers of shares are traded. Each lot is a contract. If one has to transact in the derivatives market one has to buy or sell in lots only. For example, Tata Steel has a lot size of 425 shares in the derivatives segment. If Tata Steel is to be traded in the derivatives segment one has to buy and sell a lot that consists of 425 shares. 

What is open interest?

Open interest (OI) is nothing but the number of lots or contracts that are open or outstanding.  OI is the contracts that have not been squared off. For example, Mr A buys a Nifty future contract of five lots and Mr B is the seller of the contract. Both Mr A & Mr B are not having any existing positions in Nifty. The OI will be five. Now Mr A is planning to square off his future and sell it in the market to Mr C. The OI continues to remain at five. This is because Mr A has closed his position and Mr C takes his position therefore the OI remains at one. This is because the old contracts have changed hands and no new contracts are entered. Now Mr C by selling two lots of his position to Mr B and now the OI reduces to three as the two old contracts have been squared off.

 

B sells to A >>> OI is five >> Both are new position holders >> new contract is created

 

A sells to C >>> OI is five >> One is new and the other is old position holders >> existing contract is transferred

 

C sells to B >>> OI is three>> Both are old position holders >> old contracts are closed.

 

OI is different from volume. Volume is calculated when contracts change hands. But OI is calculated only when a new contract is either created or an existing one is closed. OI tracks the existing contract movement till it is closed. In the above case when B sells to A the volume is five lots and when A sells to C then also the volume is five lots but when C sells it B the volume is three lots.

Who keeps a tab on OI?

While the shares or stocks have a fixed number of shares outstanding, futures & options do not have any fixed number of options outstanding. Futures & options contracts can be as many as the demand for them is there. It is quite possible that when one takes a long or a short derivative position, he or she can be a creator of the new position. Unlike a stock, derivatives are contracts and do not end up physically at the hands of a buyer. It only gives the holder of the derivatives the right to buy and sell the shares. However, these contracts are created and transferred and someone has to keep track of this. The National Clearing Limited formerly known as the National Clearing Corporation is the clearing agency for all the derivatives segments and keeps a tab on the open contracts.

Reading open interest

Open interest is very important as it helps understand the direction of the market.  The use of OI and price gives clues about which direction the market is headed. OI is easily available along with quotes for derivatives instruments like futures and options. This is available on the exchange website along with the option chain. An option chain is a tabular representation of option data like strike price, bid-ask for calls, bid-ask for pus, last traded price for calls and puts, per cent change in prices, volume, implied volatility for each strike of calls and puts, OI and change in OI for calls and puts. 

 

OI is calculated for each strike price and can vary from strike price to strike price. High OI at a particular strike price indicates trading interest at that strike for calls and puts. But it does not indicate the direction of the stock or index. It can indicate only interest and liquidity at a particular strike price. 

 

However, one can use OI, volume and price to reasonably predict the direction of the market or a stock. The relationship is explained in the below table.

Price Volume OI Interpretation Remarks
Increase Increase Increase Bullish All the three are up and the market is on an uptrend
Increase Decrease Decrease Short covering This means the shorts are covering their position
Decrease Decrease Increase Bearish All the three are down and the market, therefore, is in a downtrend
Decrease Decrease Decrease Long unwinding This means the longs are unwinding or exiting their position

 

An increase in open interest implies more liquidity in the market. A decrease in OI implies participants are losing interest and the money is exiting or liquidity is being taken out of the market.

Conclusion

OI on a standalone basis is of little use. One must compare this along with price and volume to understand the market movement. It is to be noted that open interest is a lagging data. Open interest for intraday is updated every three minutes on the NSE website. It is safer to use the end-of-day OI data for understanding the direction of the market.

Frequently Asked Questions

What is open interest?

Open interest in the derivatives market is the number of contracts open or outstanding. 

 

For which instruments open interest is calculated?

Open interest is calculated for the derivative instruments like futures and options. In option, OI is calculated separately for call and put options respectively for each strike price.

 

Is open interest and volume the same?

No. Open interest and volume are not the same. Volume is cumulative and OI is active contracts that have not been closed.

 

What do increases and decreases in open interest imply?

An increase in open interest means more liquidity is created in the market while a decrease in open interest implies liquidity is getting out of the market.




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