Understanding Open Interest and It’s Importance in Trading!

2 min read

While trading in the futures and options market, many of you must have come across the fact that traders face losses as they dont analyze the Open Interest. Open Interest serves as an indication of the strength of the market; it shows whether cash is flowing into or out of that particular contract.

Open Interest is one of the important parameters while trading in futures and options. While working on an open interest strategy with respect to volume and price the traders have a high probability of success in their trades and it also increases their profitability in the futures and options market. 

Lets understand Open Interest in detail along with its importance in trading.

What is Open Interest?

Open interest is a measure unique to the derivatives market. Open interest indicates how many contracts of a particular future or option are open on the market at the moment. This number changes throughout the day as traders buy and sell contracts.

This is an important number for traders to watch for the direction in which the market is trending.

Equities inherently lack open interest since the number of outstanding shares for a security is generally fixed. With options or futures, the number of available contracts in a market changes daily because new contracts can be created or liquidated at will. Open interest reflects these daily shifts. In case of derivatives, the Clearing Corporation reports a tally of all open contracts left at the end of a trading day and provides that information the next morning.

Open interest equals the total number of active, open contracts; it is not a sum of each transaction by every buyer and seller nor does it represent trades executed. Those statistics are instead encompassed in the trading volume metric. Open interest increases when a buyer or seller opens a new contract and decreases when a buyer and seller match and close their positions. If there is a greater volume of options marked “to open” than “to close,” open interest increases and vice versa. 

How Open Interest Is Calculated?

Open interest is calculated by adding all of the contracts that are associated with opening trades. Then, subtract all of the contracts that are associated with closing trades. For example, three traders (trader A, trader B, and trader C) are all trading the Nifty Futures market. Their trades might affect the open interest in the following way:

  1. Trader A enters a long trade and buys one contract.

Open interest increases to 1.

  1. Trader B enters a long trade and buys four contracts.

Open interest increases to 5.

  1. Trader A exits their trade and sells one contract.

Open interest decreases to 4.

  1. Trader C enters a short trade and sells four contracts.

Open interest increases to 8.

Open interest becomes more complicated when you consider that each of the traders is buying/selling from someone else who is selling/buying. But in the huge market, sometimes both parties will be only opening trades and increasing open interest; or one party will be closing a trade and the other opening resulting in no effect on open interest. And a lot of times, both parties could be closing trades and dropping the open interest.

What Does High Open Interest of Call and Put Indicate?

A high Open Interest build-up for a call at a particular strike implies a resistance at that strike price. A high Open Interest build up for a put option at a particular strike implies support at that price.

Why Is Open Interest Important?

By analyzing Open Interest carefully, traders can understand where all the smart people are betting their money, and this way you can easily gauge the short term support and resistance for the market. The highest Put option Open Interest strike will be the support and highest Call Open Interest Strike will be the resistance for the market.

For instance, increasing open interest along with an increasing future’s price indicates that the upward price movement could continue. But decreasing open interest along with an increasing future’s price shows that the upward price movement may be about to reverse.

Open interest is also used to determine if a market is likely to be trending or range-bound commonly known as choppy. Increasing open interest shows that the rate of new positions is increasing. This indicates that the market is being actively traded and is more likely to trend.

To sum it up, open interest can serve as an important piece of information to assess a potential investment, but one should not invest based solely on open interest; however, one can use it to help assess sentiment for a particular investment.

Disclaimer: Any advice or information in the post is a general advice for education purpose only and is not responsible for generating any trading strategy for anyone, please do not trade or invest based solely on this information.

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