Open Interest and its calculation
Before we wrap up this course on “Futures Trading”, let’s take a look at one of the many commonly asked questions – What is Open Interest (OI)? How does it differ from Volumes? How can these data be used to benefit traders?
Let’s understand in detail in this chapter.
Open Interest is the amount of contracts currently being traded on the market – a buyer for every seller. Each trade involves two parties, and when one contract is sold it is said that the buyer has gone long, whilst the seller went short. Therefore, the Open Interest would be 1 for this particular case.
Let me use an example to help explain OI. Suppose there are five traders in the market, referred to as Arjun, Neha, Varun, John, and Vikram; who trade NIFTY futures. To comprehend the fluctuations in open interest we must follow their daily activity with some level of attention. If we do not pay close attention it can be quite overwhelming.
Let’s get started.
Arjun, Varun, and Neha’s activity is documented in the table below: Arjun purchased 6 contracts, Varun 4, and Neha sold off all 10. The net result of this transaction is the same amount on both sides of the market; 10 contracts long and 10 short. Thus, the open interest stands at 10.
On Tuesday, Neha wanted to shed 8 of the 10 contracts she possessed, so John joined in on the 8 short contracts. There was no creation of new deals; merely a transfer from one person to another. Consequently, the Open Interest (OI) remained at 10.
John wants to further bolster his short positions by adding 7 more contracts, while Arjun and Varun both choose to expand their long positions. Consequently, John sells 3 contracts to Arjun and 2 to Varun, creating five additional new contracts. Neha opts to close out her open positions, transferring two of her short contracts back to John, leaving her with no more contracts.
By Wednesday’s end, the market is composed of fifteen long and fifteen short positions, collectively creating an Open Interest (OI) number of fifteen.
On Thursday, a man named Vikram arrives at the market with 25 contracts. John liquidates 10 of his contracts, exchanging them for 10 contracts from Vikram. Arjun then buys 10 more from him and Varun takes the last 5. This brings the overall count to 30 – 15 new ones added to the system.
On Friday, Vikram opts to settle 20 of the 25 contracts he had earlier sold. He purchases 10 contracts from each Arjun and Varun. This reduces the overall OI by 20, thus concluding with 10.
At this point, you should have a grasp of what Open Interest is. It simply reflects the number of open positions in the market. Note that if you assign a +ve sign to long positions and a -ve sign to short positions and add them together, the sum will always be zero. This makes sense when you look at it more closely; wealth is being transferred from buyers and sellers, not created – like with stocks when their prices increase. Thus derivatives are often referred to as a “zero-sum game”.
As of 4th March 2015, Open Interest (OI) on Nifty futures is estimated at 2.78 Crores, indicating that there are both Long and Short Nifty positions amounting to the same figure. An additional 55,255 (0.2%) contracts were added today. OI is a valuable gauge in gauging the liquidity of the market – higher OI translates to higher liquidity providing an environment conducive for entering or exiting trades with relative ease.
– OI and Volume interpretation
Open interest information tells us how many contracts are active in the market, whereas volume data shows us how many trades have been completed on a given day. As an example, if 400 contracts were bought and 400 were sold over the course of a day then the total volume for that day would be 400, not 800. It is important to note that these two figures are distinct from one another; although they both reveal something about market activity. The volume counter starts at zero each morning and increases as new transactions take place. Meanwhile, open interest can increase or decrease depending on traders entering and exiting the market – in our sample case, this could be summarized through an OI and volume analysis.
Take a look at how OI and volume vary on a daily basis. Today’s volume does not necessarily mean the same for tomorrow, whereas open interest may prove to be significant. Individually these two figures don’t tell us much about the market. However, traders often use them to make assumptions about the situation.
Unlike volumes, Open Interest (OI) does not necessarily provide any clues about the direction of the markets. What it does tell us is the strength of bearish and bullish stances. The following tables show how price movement and OI changes can be used to understand traders’ perspectives.
Take heed if the Open Interest shows an unusual rise or decline along with a surge or drop in prices. It implies that traders have tremendous optimism and investment involved, so even a little spark may cause a great deal of hysteria.