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Understanding Open Interest
What is open interest in the futures & options segment?
Open interest is the number of outstanding futures & 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 contracts 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 & the counter party is either Y or B, then the open interest the open interest in the system will reduce by that quantity. But if X unwinds his his position & the counter party is a new entrant, say C, then the open interest will unchanged. This is because while X has squared off his position, C's positions 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 indicates 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 future closes at 3000 & 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 close at 3050, S&P Nifty at 3060 (discount reduces to 10 points) & open interest rises to 1.25 crore, then it means, investors have created long positions.
In other scenario, if open interest in the contract rises, but price falls, then it indicates that investors are cautions or bearish. In short, investors are creating short positions. Now, in case open interest in the futures contract falls, but its price moves up, it indicates a bullish trend. This situation is a result of covering of short positions> In another scenario where there is a fall in open interest & price too, analysts read it as a bearish signal, as investors are liquidating their 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 enables traders calculate the put call ratio (PCR)-a popular sentiment indicators of options trader 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 & price 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 trader perceive an abnormally high open interest in a rising market as a 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 as self-feeling fall.