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Wednesday, November 30, 2016

What Is Open Interest and How To Use It To Find Bull / Bear Signals?

Open Interest is the term which defines the number of outstanding contracts in the Futures & Options (F&O) segment as at the end of a particular day.

Outstanding contracts are those unexpired contracts that are yet to be exercised. 




How to Calculate Open Interest. 

Note that for any new contract to be initiated in the F&O segment, there must be a seller and a buyer to the contract. 


When both the parties (seller and buyer) initiate a new contract, Open Interest increases by 1. 


When both the parties (seller and buyer) close an existing contract, Open Interest will decrease by 1. 


However, when an existing party closes his position by selling it to a new participant, Open Interest does not change as the contract still remains open.  

A more meaningful understanding of the term 'Open Interest' can be obtained from the following example: 


Lets say on 1st of October, A sells 5 future contract to B. In this case the Open Interest Position increases by 5 as 5 new contracts are entered into. 

On 5th of October, A buys 1 future contract from B. In this case the Open Interest decreases by 1 as one contract is squared off. This is because both the parties enter into a position that offsets the position they originally had. Note that an open position in a Futures contract can be closed by taking a position that is opposite to the one you already own. 

Now, on 15th of October, B sells his 4 future contracts to D. In this case the Open Interest remains unchanged as no new positions are entered into. D simply replaces B in the chain. 

Using Open Interest To Find Bull/Bear Signals 

How open interest can be used to find bullish or bearish signals is captured by the following discussion: 


In a rising market, an increase in Open Interest confirms a bullish trend. On the other hand when there is a decrease in Open Interest in a rising market, the market may turn Bearish soon. 

Similarly, in a falling market, an increase in Open Interest confirms a bearish trend. However, when in a falling market we see a fall in the Open Interest position, it could signal a trend reversal and the markets may start rising soon. 

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