Open interest which is also known as OI, in short, is the total number of options or futures contracts of a particular security or index that are not closed or delivered on a particular business day.
How is open interest Calculated?
Let’s try to understand open interest by an example. Let’s say we have a trader A who buys 1 future contract of Reliance Industries from trader B (who is the seller here), then open interest of that security (Reliance) is 1.
Now another trader C wants to buy 2 futures contracts of the same security (Reliance in this case) from trader D (seller), then the open interest rises by 2 and becomes 3. Now, if trader A wants to sell (unwind) his/her position and the counter party is either B or D, then the open interest of the security will reduce by that quantity (one in this case). However, in case trader A unwinds his position and the counter party (sell Reliance futures) is a new entrant, say E, then the open interest will remain unchanged. This is because while trader A has squared off his position, E’s position is still open. (This is because only the trader hands are exchanged; no new contract is sold or written).
Below is a simple table to understand the calculation of open-interest,
In conclusion we can say, if a new buyer (trader A) buys 1 contract and a new seller (trader B) sells 1 contract then the open interest will increase by one contract. If one old buyer (trader A) and one old seller (trader D) are closing an existing position, open interest will decline by 1. However, if an old buyer sells his contract to a new buyer then the open interest will not change.
How to interpret open interest and its relation with price movement?
Tracking open interest alone does not signify much information; however, its relation with price movement will give a lot of information regarding the current trend in the particular contract to the trader and investors.
Below is the chart showing the relation between Open Interest (OI) and contract price.
From above chart, we can conclude,
- Open Interest Rising: Gives an indication that the present trend (uptrend, downtrend or flat) is likely to continue.
- Open Interest Falling: Gives an Indication that the present trend (uptrend, downtrend or flat) is likely to change or is coming to an end.
Unlike volumes, the change in open interest does not really give any directional view on markets. However, it does give a sense of strength between bullish or bearish trend. Generally, if there is a sudden high open interest backed by a rapid increase or decrease in prices of the stock or index then it’s the time to be cautious. As this situation simply indicate that there is a lot of buzz and leverage being built up in the market. So any sudden good or bad news could trigger a big upswing or downswing in the stock or index.
The Open Interest position calculated every day is either positive or negative versus the previous business day. For example, below is the Reliance future OI for the July contract.
From above we can see, the OI is 1.57% more than its previous day OI. More position would mean more cash inflows into the market, while a decline in position would simply mean liquidity and that the current price movement has reached its top or bottom and time for a possible reversal in trend.
Traders, who trade in derivatives, track price movements in terms of premium and discount of contracts in relation to cash markets. All these analyses are based on the relationship between futures contracts and their corresponding spot prices also known as cost-of-carry. It primarily indicates the sentiment of the participants on the basis of the premium or discount.
Bottomline
Open Interest (OI) is a number that tells you how many contracts of the particular script are currently outstanding (open) in the market. Open interest increases when new contracts are added and it decreases when contracts are squared off. Open interest will not change where there is merely a change of hands from one party to another. Unlike volumes, open interest is continuous data.
