The Hindu Business Line : Open interest as a barometer of derivatives market

If the markets are on an uptrend and open interest is also increasing, it is a bullish signal. It implies the entry of new players, who are creating fresh long positions and suggests the flow of extra money into the market.

Would you like to be an active player in the derivatives market? If so, "open interest" is an important market indicator that could lead you in the right direction. By definition, open interest means the total number of open contracts on a security, that is, the number of future contracts or options contracts that have not been exercised, expired or fulfilled by delivery. Hence, we can say that the open interest position at the end of each day represents the net increase or decrease in the number of contracts for that day.

However, it is to be noted that open interest is not the same as trading volume. Trading volume represents the total number of contracts that are traded during a day, inclusive of both squared-off (closed) positions and new positions. Thus, for any day, the trading volume will always be higher than the open interest.

What is Open Interest

Every trade in the exchange would have an impact on the open interest for that day. Say, for example, `A' buys one contract of Nifty on Monday while `B' buys two on the same day. Open interest at the end of the day will be three. On Tuesday, while `A' sells his one contract to `C', `B' buys another Nifty contract.

The open interest at the end of the day is now four. In other words, if both parties to the trade inititate a new position, it increases the open interest by one contract.

But if the traders square off their existing positions, open interest will decrease by the same number of contracts.

However, if one of the parties to the transaction squares off his position while the other creates one, open interest will remain unchanged.

Open interest, thus, mirrors the flow of money into the derivatives market, which makes it a vital indicator of market direction. Here is how you interpret open interest:

Rising market and increasing open interest

If the markets are on an uptrend and open interest is also increasing, it is a bullish signal. It implies the entry of new players into the market, who are creating fresh long positions and suggests the flow of extra money into the market.

Rising market and decreasing open interest

If despite a rise in market, the open interest decreases, it can be interpreted as a precursor to a trend reversal. The lack of additions to open interest shows that the markets are rising on the back of short-sellers covering their existing positions.

This also implies that money is flowing out of the market, given that open interest is decreasing.

Falling market and increasing open interest

When open interest records an increase in value amidst a falling market, it could be a bearish signal. Though a rise in open interest means that new trading positions are being created and fresh money is getting routed into the market, the new money is probably being used for creating fresh short positions, which will lead to a further downtrend.

Falling market and decreasing open interest

If open interest decreases in a falling market, it can be attributed to the forced squaring-off of long-positions by traders. It, thus, represents a trend reversal, since the downtrend in the market is likely to reverse after the long positions have been squared off.

Thus, in a falling market, a declining open interest can be considered a signal indicating the strengthening of the market.

Sideways market and increasing open interest

When the market is range-bound and there is marked rise in the open interest, we can expect a significant movement in the market. However, the direction of the move cannot be predicted.

Sideways market and a decreasing open interest

If the open interest decreases in a sideways market, we can say that flat market trends will continue for some more time.

A decrease in open interest only represents the squaring-off of old positions and lack of any new positions might result in a sideways or weak trends in the market.

Though open interest is a good barometer of where the markets are heading; it is only an indicator that helps us trade intelligently; it cannot be considered foolproof.