Understanding Open Interest (OI) in the Derivatives Market

Open Interest (OI) is a fundamental concept in the derivatives market, reflecting the total number of outstanding contracts that have not yet been settled. By understanding OI, traders can gauge market sentiment and liquidity effectively.

What is Open Interest?

Open Interest refers to the total number of active contracts (options or futures) that remain unexercised or unclosed. Each buy transaction corresponds to a sell transaction, and together they count as one Open Interest.

Once an option is bought or sold, it contributes to the Open Interest until it is closed out or expires. Essentially, Open Interest signifies the total number of futures and options contracts in the market that are still active.

Open Interest vs. Volume

While OI and volume may seem similar, they serve different purposes:

Volume represents the total number of contracts traded during a specific period, including both settled and open transactions. Volume resets to zero at the start of each trading session.

Open Interest reflects the number of contracts that are still open and will continue from one session to the next. It changes only when contracts are opened or closed.

Key Differences

• Starting Point: Volume starts at zero each trading session, while Open Interest carries over from previous sessions.
• Market Activity: High volume may indicate active trading within a day, but it doesn’t provide a long-term picture like Open Interest does.

Open Interest is specific to the futures and options market; it is not applicable to stock markets. Thus, OI figures are available for various assets, including forex, stocks, crude oil, indices, commodities, silver, natural gas, and gold.

How open interest (OI) is created?

In futures and options markets, the number of open contracts changes daily based on market participants‘ expectations.

• Bullish Sentiment: If market participants are optimistic, they will open positions anticipating price increases.
• Bearish Sentiment: Conversely, if they are pessimistic, they will open positions anticipating price declines.

Open Interest (OI) increases when new positions are opened and decreases when positions are closed. For example, if a trader opens 20 call option contracts, OI increases. However, if existing contracts are transferred between traders, OI remains unchanged, as this does not involve closing any positions.

OI only rises when new contracts are created; for instance, if Buyer B1 and Seller S1 enter into a new contract, OI increases, but if B1 sells that contract to Buyer B2, OI stays the same.

Analyzing Open Interest Trends

Open Interest can provide valuable insights into market trends:

• Increasing Open Interest: Indicates that more traders are entering the market, suggesting a confirmation of the current trend. Rising OI often reflects increased liquidity and new money flowing into the market.
• Decreasing Open Interest: Signals that traders are closing positions, potentially indicating a loss of confidence in the current trend. Low OI can lead to lower market liquidity, making trading more difficult.

Traders often use Open Interest to identify potential support and resistance levels:

• Support: Typically found at strike prices with high Open Interest on the put side.
• Resistance: Usually at strike prices with high Open Interest on the call side.

Market participants can calculate put call ratio to know the probable direction of the market. If put call ratio is greater than 1, then we have higher longs in puts compared to calls. This means market is expected to fall further.

Understanding Market Movements

Understanding how Open Interest (OI) interacts with price movements can provide valuable insights into market sentiment and trader behavior. Here, we break down four key scenarios that traders often encounter:

• Short Buildup: This occurs when OI increases while prices are falling. In this situation, more traders are opening short positions, betting that prices will decline further. This rising OI indicates that bearish sentiment is growing—traders expect a downward trend and are positioning themselves to profit from it. It’s important to watch for this scenario, as it can suggest increased selling pressure in the market.
• Short Covering: When prices rise and OI decreases, it signifies that traders are closing their short positions. As these traders buy back the contracts they previously sold, it creates upward pressure on prices. This scenario often indicates a shift in market sentiment, as traders who were once betting against the market now believe that prices might rise, prompting them to cover their positions. This can lead to a price rally, especially if many traders start to cover simultaneously.
• Long Buildup: In this scenario, both OI and prices are rising. This indicates that more traders are entering the market with long positions, anticipating that prices will continue to go up. This buildup can signal strong bullish sentiment, suggesting that traders are optimistic about future price movements. It’s a sign of confidence in the market, often supported by positive news or strong fundamentals.
• Long Unwinding: When both prices and OI decline, it indicates that traders are closing their long positions. This scenario often arises when traders are becoming cautious or bearish, believing that prices will fall. As they sell their positions, OI decreases, reflecting reduced interest in holding long contracts. This can create a negative feedback loop, potentially driving prices down further as more traders follow suit.

Understanding these scenarios can help traders gauge market sentiment and make informed decisions about their positions.

Market Wide Position Limit (MWPL)

Open Interest is subject to regulatory limits set by exchanges, known as the Market Wide Position Limit (MWPL).

MWPL is the maximum number of open contracts allowed in a stock at any time.

If Open Interest exceeds 95% of MWPL, exchanges may restrict new positions, allowing only the exit of existing positions until Open Interest falls below 80%.

Open Interest is a powerful tool for traders looking to understand market dynamics. By analyzing OI along with volume and other market indicators, traders can make more informed decisions. It’s crucial to compare current Open Interest with historical data to identify significant changes that may signal future price movements.

Also Read: European vs. American Options: What is the difference?

By monitoring Open Interest, traders can gain valuable insights into market sentiment and liquidity, enhancing their trading strategies.