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In the world of futures and options, open interest (OI) is one of the key analytical tools that help one take a price view on stocks and even on the indices. Unlike equity shares that are limited by the number of shares issued, there is no such limit on open interest. However, in the interest of keeping a check on speculation, the exchange limits open interest with the use of market-wise position limits (MWPL).
Let us first see how OI is created with an illustration of lots on SBI. The numbers refer to long/short in lots of SBI.
Details | Day 1 | Day 2 | Day 3 | Day 4 | Final OI |
---|---|---|---|---|---|
Ashok | +10 | +10 | +15 | -12 | +23 |
Rajesh | 0 | -5 | -5 | +6 | -4 |
Manish | -5 | -3 | -8 | +3 | -13 |
Naresh | -5 | -2 | -2 | +3 | -6 |
One of the most common questions of traders is “How can I use open interest to increase my profit?” The answer is proper OI analysis. Keep reading to find out how to interpret OI in different scenarios.
If you see the price of the stock increasing along with an increase in open interest, then it indicates strength behind the price move. It indicates that the price is moving up on the back of aggressive buying in the stock futures. You can position yourself by buying into the futures, but you need to keep watching for the signal when this relationship turns around. This is a sign of strength and indicates higher price movement.
This is an indication of short build up in the stock futures. Short build up happens due to two reasons. One could be a negative view of the stock which is inducing traders to sell the futures. Alternatively, it could also be a case of fresh arbitrage positions being built in the stock, wherein traders buy in the cash market and sell in the futures for assured spreads. An arbitrage is actually positive for the markets but also indicates that traders are not entirely bullish. Fresh shorting could either be due to structural reasons or purely as a short-term trade. Either way, short covering is likely to offer support at lower levels. You can position your trade either on the short side or as a ‘buy on dips’ approach.
This is a case of Short Covering which is explained by the reduction in open interest. Existing holders are taking their profits and exiting their positions in the market. Most likely, it is shorts that are being covered. This could have two interpretations for you as a trader. You can be cautiously bullish on the stock and put your trades accordingly. The other option is to use higher levels to sell the stock as this is a case where the stock is likely to lose its upward momentum when the short covering is completed.
This is a fairly bearish scenario where traders are actually offloading their long positions in the market and this explains the reduction in the open interest. The fall in price indicates that there is neither short covering in the markets nor is there any buying that is coming in. In fact, this scenario is common when arbitrageurs are unwinding positions in the market. Normally, when the price is falling with a fall in open interest, it also indicates a lack of buying interest in the cash market. This is a clear indication to unwind long positions and initiate fresh short positions in the stock.
There is one important thing to remember in case of options. Normally, large institutions and informed investors are on the sell side of calls and puts. So, if you see an aggressive increase in open interest in puts, it is most likely being led by the institutions who are selling puts and it hints at a support level below which the market is unlikely to fall.
The reverse interpretation holds in case of call options OI movement. You can position your trades accordingly. In fact, while designing you cash market and futures trades, you can use the options OI data as a confirmation data point.
Open Interest plays a key role in helping traders understand market sentiment and build strategies accordingly. But how to use open interest to maximise your profit? Here’s a detailed description:
Using OI effectively allows traders to make informed decisions and spot opportunities in futures and options trading.
Many traders rely on Open Interest without fully understanding its limitations. Avoiding common mistakes can help you make better trading choices.
Staying aware of these pitfalls will help you use Open Interest more effectively in your trading strategy.
Open Interest offers valuable insights into market sentiment, trend direction, and potential reversals when used alongside price and volume. It is a powerful tool for options and futures trading. By avoiding common mistakes and focusing on accurate interpretations, traders can make smarter decisions, reduce risks, and identify opportunities that align with broader market movements for better trading outcomes.
Open Interest is the total number of outstanding contracts that are active. OI provides an understanding of market participation or money going into or out of a position. Trading volume reflects the number of contracts traded over a period of time.
A rise in Open Interest during intraday trading usually reflects new positions being taken, long or short, demonstrating more vigorous market interest. It assists in verifying whether a price movement is supported by genuine conviction or mere short-term volatility.
Yes, Open Interest can hint at trend reversals when its movement contrasts with price action, like rising prices with falling OI, indicating short covering. Observing such patterns helps traders assess if a trend is weakening or about to shift direction.
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