Open Interest Essential Trading Tool

July 25th, 2011 Praveen Bajaj

Many a times you would have come across statements like Open interest in XYZ increased 20 percent, but not many of us are comfortable with the idea of Open interest and many others confuse the same with volume. I will try to clarify this concept through this article.

First let me explain you, what is the open interest and why is it important?

The word open in open interest itself says that the contract is open. Open interest means unsettled derivative contract for a specific underlying security like Future and Option. Simply it can be also summarized as contracts outstanding on a particular day.

How can the contract be open??

For trading in future market there must be two parties involved. One is buyer and other is seller.

1) Suppose the buyer Mr. A buys contracts from Mr. B, the open interest is 1 and the contract is said to be OPEN.

2) Again the same contract is sold by Mr. A to Mr. B the open interest will become 0. The contract is simply closed.

3) If the contract is sold to the new party i.e. Mr. C, The open interest will remain same because Mr. A closes the contract but Mr. C open a new contract.

Now I am sure you must be clear that why it is called an open contract.

At this point one question must be coming in your mind that impact open interest in the market?

Before giving my view on this, following should be kept in mind:

• Only an increase in volatility or open interest does not necessarily indicate anything about the future price movements
• If the open interest increases suddenly it is likely that the new information about the underlying security is being revealed which may increase the volatility
• It also shows that there is strength behind the current price movement. Overall increase in open interest implies flowing of new money into the market, and hence we can conclude that the present trend will continue.

To what extent is the concept of open interest important for a trader and specifically for an option trader?

• An option trader can draw certain conclusion by monitoring changes in the open interest figures both during the day as well as comparing End-of-day data
• An increase in open interest along with an increase in price is said to confirm an upward trend.
• An increase in open interest along with a decrease in price confirms a downward trend.
• If the prices increase or decreases while the open interest remains flat or declining may indicate a trend reversal (change in the direction of the market).

CALCULATION OF OPEN INTEREST

It is important to know that there are two type of trade, one is opening trade (purchase) and another is closing trade (selling or squaring off).

In simplest words Open interest is calculated by adding all the opening contract trades and subtracting all the closing contracts trades. Let me give you another example:

Take the above example three traders Mr. A, Mr. B, and Mr. C.

1) Trader A enters a trade by buying 1 contract from Mr. C Open Interest increases to 1

2) Trader B enters a trade by buying 4 contracts from Mr. C Open interest increases to 5

3) Trader A exits by selling one contract to Mr. C Open interest decreases to 4

4) Trader C enters a short trade by selling four contracts to Mr. A Open interest increases to 8

RELATION BETWEEN PRICE AND OPEN INTEREST AND ITS IMPLICATION

The Relationship between the price and open interest can be summarized by the following table:

It is important for trader to understand the concept more clearly to sustain strongly into the market. While analyzing the future and options market remember considering open interest to get more accurate expectation. Open Interest gives a fair idea to the trader that regarding market gaining strength or getting weaker.

Remember knowledge is a tool for the trader to make money. Any type of query, advice and suggestions are appreciated. It’s your money, invest wisely.

Author: Satish Tayal, MBA (ISB&M) is an intern at Kredent Finance