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Open Interest: What it means to traders

We all know Futures and Options, or for that matter, any derivative instrument would actually sum up to have a zero-sum pay-off, considering there is a Long for every Short. However, in an attempt to make these bets, we do find traders like you and me, we end up painting a picture of our mood in totality.

Today, let us have a look at one such data point and try to gauge if we can, some sort of directional perspective on the underlying. The data in analysis would be that of Open Interest and the subject matter of such observation would be Futures.

Open Interest, as we all know, is nothing but accounting of total number of contracts outstanding as on that time in any particular instrument. Having said that, unlike volumes, every new Buying and Selling may not account for fresh Open Interest.

Meaning, A Buys instrument X, B Sells instrument X and one lot of open interest is created. Now with the next transaction, 3 things can happen:

-C wants to Buy one lot of instrument X, and A Sells it to C. This accounts for an additional transaction with the Open Interest remaining the same as no new contract was created.

-C wants to Buy one lot of Instrument X and D comes and Sells instrument X. Thereby, now having 2 transactions between 4 parties and a creation of yet another contract. Open Interest turns 2.

-B who earlier sold wants to Buy back instrument X and A agrees to Sell it. Here, the new transaction takes place between the same parties squaring off their original positions. This would lead to an unwinding of that 1 lot open interest, making Open Interest Zero.

Out of all these 3, most of the transaction would fall under situation #1. But situation #2 & #3 are the ones which we are more interested in. Situation #2 especially where there was open interest addition. This is helpful is because it is indicative of the fact that there is additional trading interest in the underlying with fresh directional expectation. Once we understand this bit of Open Interest data creation, we can now go on to associate Price to the Creation and Unwinding of open interest, which will help us have 4 different combinations of derivatives data.

Now considering the instrument under question is Futures. Let us see what each of these four combinations imply.

If Price is Up and Open Interest has also Increased, isn't it safe to assume that the Buyer had lower bargaining power in creating positions? In other words, if I am expecting Stock X @ 100 to go up to 110, I wouldn't mind Buying it at 101 as at this moment the position creation is more essential than hunting for bargains.

This means that whenever we see Price Up and Open Interest added, it could be inferred as additional bullish bias added into the stock. Similarly, with the same logic, the setup in the other way around also can be justified. Whenever we see Price Down and Open Interest added, it could be inferred as additional bearish bias added into the stock.

Now for the unwinding, here the open interest is in a reduction mode. Alongside it, if we see a reduction in Prices, could actually mean that pressure from sellers was higher. Now, who would be selling to unwind their position? The answer is, one who has existing Longs.

Thus, we could conclude Reduction in both Price and Open Interest could be labeled as Long Unwinding and on the flipside of the same logic, Increment in Price with Reduction in Open Interest could be seen as Short Covering.

Out of personal experience, this data alone has never been enough to base trades on but analyzing the futures Open Interest data has always given timely insight into the consensus getting built into the underlying.

What we discussed today may just be the tip of the iceberg in terms of making sense of derivatives data but make a start with this piece of data and it would open up deeper insights which if not help take a trade would definitely help filter a good trade out of many available.

-From Web