Open Interest Explained.
Posted by eqpulse
WHAT IS OPEN INTEREST?
In derivatives trading, open interest, or OI, is the total number of outstanding futures or options contracts in a market at a given point of time. It is measured throughout trading hours and displayed real time on exchange websites and trading terminals. For example, at the end of market hours on Thursday, Nifty May futures on NSE had an open interest of 2.08 crore, up 3.87 lakh from the previous session. As opposed to trading volumes, which capture total buying and selling activity, open interest counts how many positions were created; that is, how many are still ‘open’.
HOW DOES OPEN INTEREST CHANGE?
Every futures or option trade has a buyer and a seller. The buyer can hold the contract till expiry or sell it to another buyer or liquidate it before expiry. Each action changes open interest differently. For example, if trader A buys 10 futures contracts from trader B, then open interest is 10. If another trader X buys 20 futures from trader Y, then the open interest accordingly adds to 30. But, if A unwinds his position of 10 futures, then open interest will decrease by 10, because these contracts cease to exist. Instead, if A sells these to another trader C, then the open interest remains unchanged since it is C who holds the contracts now.
HOW IS THIS DIFFERENT FROM TRADING VOLUMES?
In the above example, while open interest increased or decreased depending on the type of trade, trading volume only increased. When A bought 10 futures, trading volume was 10 and when X bought 20 contracts, volume rose to 30. But, when A unwound his position, open interest declined by 10, but trading volume increased to 40.
HOW TO INTERPRET OPEN INTEREST?
Analysts and traders commonly track open interest to observe unusual buildup of positions in a contract.However, open interest positions should be cross-checked with other parameters such as price.For instance, a rise in contract price along with increase in OI means long positions are being created, which are inflating the contract’s price. But if OI has reduced, then it means the inflation is caused by traders covering their short positions. Conversely, if price falls along with a rise in OI, then it means more traders are building short positions and pushing the price down. If OI falls along with the price, then it means long positions are being unwound. For futures contracts, savvy traders further look at changes in the discount or premium to the spot price to get a clearer picture of the market. So, if premiums contract, or discounts widen, along with an increase in OI, it means short positions are being added, and if OI is reducing, then it means long positions are being closed. Conversely, an expansion in premium or contraction in discount along with rise in OI means long positions are being added. In the options segment, such a direct relationship between option prices and open interest doesn’t exist. However, open interest is used to calculate an indicator called putcall ratio or PCR-OI. It is the ratio of total open interest in put options to that of call options. Traders use this to determine if a market is oversold, or overbought, thus predicting medium-term trends in the market.
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Posted on May 25, 2012, in Capital Market, News and tagged Buyer, Discount, Expiry, Future, Liquidate, National Stock Exchange, Nifty, NSE, Open Interest, Options, options contracts, outstanding futures, Premium, Seller, Trade, Trading Volume, unwinding position. Bookmark the permalink. Leave a comment.