By Vishweshwar HS, www.showmytrade.com
Open interest analysis is an essential tool for traders with technical analysis for identifying stocks trend in the stock market. For the stocks that have Future & Options contract, open interest is a good indication of the market trend. In this article, we learn the highest open interest to identify the market trend. Let us begin by learning what is open interest and its meaning?
What is the open interest?
Before understanding the open interest, we must first know how futures and options contracts created. The contract will exist if a buyer and a seller do the transaction. For every buyer of a contract, there must be a seller of a contract since one cannot buy if someone is not selling it.
Open interest (in derivative context) is nothing but the total number of outstanding future/options contracts, such as futures or options that have not settled or closed for a stock. The total of every buy and sell will not count in the open interest. Thus, open interest provides a more accurate picture of the future & options trading activity. And the money flows into the future, and the options market is increasing or decreasing, which clearly shows us market trends.
Open Interest Changes
It is correct to note that open interest equals the total number of contracts that are not closed. It is not about the total number of buy and sell. We can say open interest is total of all the buys or all of the sells, but not set-off of both.
The open interest number keeps changing when a new buyer and seller trade in that stock, results in a new contract, or when a buyer and seller meet—thereby were closing both open contract positions.
For example, if one trader has five short contracts and another has five long contracts, and these traders then buy and sell five contracts to each other, those contracts are now closed and will be deducted from open interest.
Interpretation of Open Interest Analysis
(1) Long Built-Up
An increase in open interest and also with an increase in price mostly indicates long positions being built up, except for very weak stocks where some traders may short the stock on a rally.
(2) Short Built-Up
An increase in open interest and also with a decrease in price mostly indicates short positions being built up, except for very strong stocks where some traders may buy the stock on declines.
(3) Long Unwinding
A decrease in open interest, and also with a decrease in price, mostly indicates long unwinding.
(4) Short Covering
The decrease in open interest, and also with an increase in price, mostly indicates short covering, except for weak stocks where traders may decide to book profits/cut losses at higher levels. It may also mean delivery based buying by institutions that push up the price, and speculators use it to unwind.
One Practical Example of Open Interest
Let’s study the below table of trading activity in the Future market for traders, A1, B1, C1, D1, and E1. Open interest calculated following the trading activity for each day.
|Time||Trading Activities||Open Interest|
|A1 buys 1 fut. & B1 sells 1 fut. contract|
C1 buys 5 fut. & D1 sells 5 fut. contracts
A1 sells1 his fut. & D1 buys 1 fut. contract
E1 buys 5 fut. from C1 who sells 5 contracts
The above Table shows how open interest changes.
- Day 1: Open interest increases by one since only one contract created consisting of a buy and sell.
- Day 2: Five new futures contracts created such open interest increases to six.
- Day 3: Open interest declines by one because traders A1 and D1 sell one contract to close their open positions. As we know by now that open interest is not the total of both, buy and sell trades.
- Day 4: Open interest remains at five since there are no new contracts created. Investor E1 bought five existing contracts from C1.
The Bottom Line
Open interest is associated with the futures and options markets. Open interest analysis is to study the total number of outstanding or unsettled F&O contracts. Increasing open interest means new or additional money coming into the market, while decreasing open interest indicates money flowing out of the market.
Open interest analysis helps the F&O traders get a sense of if a market is an uptrend or downtrend with strength. It is essential to know and study the Open interest in a highly profitable trade. As an investor, the more you know, the less likely you are to be caught off-guard in a losing trade. It’s your hard-earned money, so trade it wisely!
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