One of the most important parameters to suspiciously consider while trading in the derivative market is open interest. Taking OI into consideration will always give us an indication to predict the range of the market in an intelligent way. Always consider open interest in any futures and option segment before entering a position. Let’s discuss Open interest and its impact into the F&O segment.
What is open OI and why is its significance so vital??
Open interest defines the total number of open or outstanding contracts active at any point of time which are created by the market participants. You can go to https://www.nseindia.com/option-chain to see the NIFTY open interest data for various indices and F&O activated Stocks as well.
Many people who come into the market especially into the Futures and Options segment they. wanted to know what is open interest at various levels for the underlying. As the Name suggests Open interest indicates the interests of traders for a particular strike price at any point of time. OI increases only when new contracts are added and decreases only when contracts are squared off. OI does not change when there is transfer of contracts from one party to another, and also the intraday trading will not get reflected in the OI data at the end of the day as such trades get squared off in the same day itself.
If you are Buying 1 Lot of Nifty Futures, you enter into a Contract with a seller of Nifty Futures. Thus a Contract is made between the two parties, a Buyer and a Seller for a Derivative Instrument (Nifty Futures in this case). Suppose if only your Contract exists for the instrument, then its Open Interest is 1. If you exit your position and a new buyer comes to take your position from the seller, the OI will remain 1 Only as inplace of you a new buyer is in Contract with the seller and in the market there exist only 1 Contract in overall. Suppose instead of Exiting your position, you plan to buy 2 more lots of Nifty Futures of the same expiry, if you could get a seller and execute the trade there will be 3 Contracts available in the market (Your Initial 1 Contract and 2 New contracts added now) and the Current OI for Nifty Futures will be 3. Derivative Instruments have to be purchased in lots defined by SEBI and 1 lot of the same represents 1 Contract. Unless new Contracts are made OI Value does not Change. Open Interest reflects the total number of Contracts on a Derivative instrument at any point of time.
Incase of Options there are multiple predefined Strike Prices available where we can build a contract, either we can go long or short at that strike price. For Option buying the maximum loss is limited to the premium we pay to buy it, whereas for option selling unlimited loss can happen theoretically if the trend is against us. So Exchanges necessitates naked Option sellers to keep a large upfront margin to execute the trade. Comparatively higher Capital requirement for Option selling, leads to the assumption that Sellers are Powerful in the marker in terms of Money power.
The Strike Price having maximum OI in call and put side thus helps us determine the Support and Resistance of the underlying.Technical Analysts say that the Call option strike price having the largest OI tends to act as a strong resistance till that particular expiry period. Similarly the Put option strike price having the highest OI acts as a support throughout the expiry series. One point to note is that the OI data of Options works well for analysing Indices, whereas for F&O activated stocks OI data of Futures tends to be more reliable in making an assessment regarding the Support and Resistance levels.
Does all the stocks have an Open Interest and Option Chain available??? No, it is only for the F&O activated stocks. NSE has published a list of F&O activated stocks and only those stocks will get traded on the derivatives market, so OI data will be there only for such stocks active on the F & O segment. Liquidity of Futures and Options is an important factor to be considered before trading on them, and Option Chain gives us that data. If we purchase an illiquid Option / futures we might have to face unlimited loss when the market moves against our trade, and even our Stop loss may not get triggered if the derivative is having low liquidity. So intelligent derivative traders always make sure that they trade on instruments having good liquidity, which enables them to exit their position at will. Historic datas show that Stock Futures tend to have more liquidity compared with its Options whereas Index Derivatives have more Contracts in Options rather than its Futures.
The analysis of OI along with Underlying price leads us to Four Quadrant or Four Market Scenarios, which gives us a clue of the underlying directional move
Long Build Up
If the Number of Contracts increases, ie OI increases, and the Underlying price goes up, then such a scenario is called Long Build Up. It is an indication that Long Positions are being created in the Market and the underlying asset is supposed to go up in the coming days.
For Example, if we could notice a considerable OI increase in Nifty Futures on a day compared to previous days and the market closes positively, it indicates that more people are buying Nifty Futures with a view of the market being Bullish (the Positive market closing confirms it).
If the OI value of the underlying decreases along with Decrease in Price compared with previous days, then such a Scenario is called Long Unwinding. It indicates that the market is moderately Bearish. The long positions were forced to exit because it hit their Stop Loss or the Long position holders felt that the Market is moving against their favour (ie Bearish).
For Example, if Nifty starts to move down, the Future buyers will lose money and they are forced to exit at their Stop loss or if they feel a major bearishness in coming days. This results in decrease in OI. So we could see decrease in OI along with down move in Nifty, which shows the Market is Slightly bearish.
Short Build Up
In the Long Build Up scenario we explained earlier, you might have thought when OI increases there is an increase in sellers and buyers also, then how we assume that the market is bearish with OI data as equal number of buyers and sellers are there. Note that OI data alone won’t be sufficient to analyze the trend, it was clubbed with underlying Price move. In Long Build up the Underlying asset moved up along with rise in OI. So in that case we can assume the Buyers to be more powerful, that’s why they pushed the market up.
Short Build Up is the Scenario where the Underlying asset moves down along with an Increase in OI. It shows that more people are shorting the market or the underlying, i.e. more short positions are made, which forces the underlying to go down even if OI is increasing. In the Short build up case we could see the sellers being powerful as they managed to drag down the underlying asset, which indicates a short term Bearishness in the Market or on the Underlying.
It is the Scenario where the Underlying Price goes up and the OI value Decreases. This condition indicates a Pull back or short term mild Positivity in the Market and gives a clue that the underlying can give a mild up move in coming days.
As the Market or the Underlying moved up in a day, the short position holders were forced to exit their positions either because of hitting their Stop Loss or they felt the underlying could move against their trade in the coming days. Which will lead to the decrease in OI. So when OI decreases with Up move in the Underlying it gives us indication that the underlying asset can go up in coming days.
The OI Coupled with Price to figure out the trend should be used along with Other Technical and Price action based indicators, as it could also give you false signals if used alone. Always remember higher the number of criteria used to identify trends, the probability of making profitable trades will be higher.
One Small point worth Noting regarding Long and Short Covering is that, they could also happen because of Profit booking. If you see a decrease in OI by a small percentage, it may be because of profit booking, not necessarily signifying trend reversal. If the OI decrease is by a considerable percentage, then it can be treated as a sign of reversal.