What is Open Interest?
Open interest (OI) is a critical concept in the derivatives market, particularly in futures and options trading. It represents the total number of outstanding contracts (both long and short) that have not been settled or closed. Unlike volume, which counts the number of contracts traded within a given period, open interest reflects the total open positions in the market.
For example, if Trader A buys one futures contract and Trader B sells one, the open interest increases by one. If Trader A then sells the contract to Trader C, the open interest remains unchanged. However, if Trader A closes the contract by selling it back to Trader B, the open interest decreases by one.
Understanding open interest helps traders gauge market sentiment, liquidity, and the strength of a price move. High open interest indicates strong participation and liquidity, while declining open interest signals a reduction in market interest, which could suggest an impending trend reversal.
How to Use Open Interest in Trading
1. Trend Confirmation
Open interest can help confirm trends in the market. If the price of an asset is rising along with increasing open interest, it suggests that new money is flowing into the market, strengthening the uptrend. Conversely, if prices are rising but open interest is declining, it may indicate that the trend is losing strength and a reversal could be near.
Example:
- Bullish Confirmation: Suppose the price of Nifty Futures is rising steadily, and open interest is also increasing. This suggests that fresh long positions are being created, confirming the bullish trend.
- Bearish Confirmation: If crude oil futures are declining in price while open interest is increasing, it indicates that traders are aggressively shorting, confirming a bearish trend.
2. Divergence Between Price and Open Interest
Divergences between price movement and open interest can signal potential trend reversals.
- Price Rising + Open Interest Falling: This suggests that traders are closing their positions, reducing participation. It often precedes a bearish reversal.
- Price Falling + Open Interest Falling: This suggests that short sellers are covering their positions, which might indicate a potential bullish reversal.
Example:
If Bitcoin futures are trending upwards but open interest is consistently declining, it means the rally is not supported by new money. This could lead to a sudden pullback.
3. Breakout Trading Using Open Interest
Traders use open interest to validate breakouts.
- If a stock breaks above a resistance level and open interest surges, it confirms the breakout.
- If a stock breaks down below support and open interest increases, it suggests strong bearish momentum.
Example:
- If Bank Nifty is trading within a range and suddenly breaks above resistance with a significant rise in open interest, traders can take a long position as the move is supported by strong participation.
- Conversely, if Tesla stock breaks below a key support level with increasing open interest, traders can initiate short positions.
4. Open Interest and Options Trading Strategies
A) Writing Options Based on Open Interest
- High open interest at a particular strike price often acts as strong support (for put options) or resistance (for call options).
- Traders can sell options at strikes with high open interest to benefit from time decay.
Example:
- If Nifty 50 has high open interest at the 18,000 call strike, it indicates strong resistance. Traders might sell 18,000 calls expecting price rejection.
- Similarly, if there is high open interest at 17,500 put, it suggests support, making put writing a viable strategy.
B) Using Open Interest Change to Identify Smart Money Moves
- A sudden spike in open interest with significant price movement can indicate institutional activity.
- Traders can track these movements to align their trades with big players.
Example:
If Reliance Industries’ stock shows a 10% jump in open interest along with price rise, it indicates aggressive buying by institutions. Traders can take long positions.
5. Liquidation and Open Interest Analysis
Large reductions in open interest suggest mass liquidation of positions, often leading to strong price movements.
- Long Liquidation: If prices fall sharply along with a drop in open interest, it suggests long positions are being closed.
- Short Covering: If prices rise along with a drop in open interest, it indicates shorts are covering their positions, often leading to sharp rallies.
Example:
If silver futures drop 5% and open interest also falls significantly, it indicates a major long liquidation event.
Combining Open Interest with Other Indicators
To enhance accuracy, traders often combine open interest analysis with other indicators:
- Volume: If both volume and open interest are rising, it confirms a strong trend.
- Relative Strength Index (RSI): If RSI is overbought while open interest keeps increasing, it suggests a potential reversal.
- Moving Averages: Using open interest with moving averages can confirm breakout or breakdown points.
Example:
If S&P 500 futures break above the 200-day moving average with rising open interest, it confirms a strong bullish move.
Conclusion
Open interest is a powerful tool that traders can use to gauge market sentiment, validate trends, and spot potential reversals. Whether used in futures trading, options trading, or alongside other technical indicators, understanding open interest can significantly improve trading decisions.
By integrating strategies like trend confirmation, divergence analysis, breakout validation, and option positioning, traders can enhance their ability to profit from market movements. As always, risk management should be a priority, and traders should use stop-losses and position sizing to protect their capital while leveraging the insights provided by open interest.