Open Interest Analysis – How to identify market trend?

Open Interest

Many traders and investors often ask What is Open Interest ?, What is the difference between open interest & volume ?, How can we analyse open interest and volume? etc. But no need to worry now and get set because all your questions will be answered in this post.

 

 

As the name suggests, Open Interest (OI) is the INTEREST that is OPEN.

What is INTEREST? INTEREST is the POSITIONS of TRADERS.

And What is OPEN? OPEN means OUTSTANDING.

So, OPEN INTEREST means POSITIONS of TRADERS which are OUTSTANDING and not yet squared off.

There are only two type of positions that a trader can take in the market, LONG & SHORT.

Now, since for every LONG there is a SHORT and for every SHORT there is a LONG, so we don’t count OI as LONG + SHORT but either TOTAL LONGS or TOTAL SHORTS. They both would always be equal.

So, as I said OI is a number that tells you how many futures (or Options) contracts are currently outstanding (open) in the market. So, Let us say the seller sells 1 contract to the buyer. The buyer is said to be LONG on the contract and the seller is said to be SHORT on the same contract. The open interest, in this case, is said to be one, not two.

 

How can you analyse bullishness or bearishness with open interest data ?

 

1) If PRICE is rising and OI is rising, the market is STRONGLY BULLISH.

 

Description

If PRICE and OI both are rising, it means that every new contract that is being added is dominated by bulls, that’s why PRICE is rising with every new contract addition.

Never think that since PRICE is rising, more LONGS are being created than SHORTS. LONGS will always be equal to SHORTS just that LONGS are dominating SHORTS in the transaction, that is why PRICE is rising.

See, it’s like a normal share transaction. The number of shares bought is ALWAYS EQUAL to the number of shares sold.

Then why PRICE rises or falls? It does so because of buying pressure or selling pressure. So, if buyers of a share are dominating the sellers, PRICE will rise and if sellers are dominating the buyers, PRICE will fall. But BUYERS will always be equal to SELLERS.

So, OI is rising, means new contracts are being added. But since PRICE is rising with it, it means that LONGS are DOMINATING the transactions. Thus, market/share is STRONGLY BULLISH.

 

2) If PRICE is rising but OI is falling, the market is WEAKLY BULLISH.

 

Description

If PRICE is rising but OI is falling, it means that the rise in price is due to SHORT COVERING and not bullishness. See why is OI falling? It’s falling because positions are being squared off and the number of open contracts in the market is reducing.

But since PRICE is rising with it, it means that SHORTS are SQUARING OFF and dominating LONGS in the transaction.

See, how would SHORTS square off? They will square off by BUYING. That is why PRICE is rising.

So, PRICE is not rising because LONGS are dominating. It is rising because SHORTS are dominating the squaring off process. Thus, it can not be called BULLISH. It is WEAKLY BULLISH. It can be a TRAP for new LONGS.

 

3) If PRICE is falling, OI is rising, the market is STRONGLY BEARISH.

 

Description

If the price is falling and OI is rising, it means that SHORTS are dominating the LONGS. And since OI is rising, it means that new contracts are being added.

But, since the price is falling, it means the new contracts which are being added are dominated by SHORTS, not LONGS. Hence, it is STRONGLY BEARISH.

 

4) If PRICE is falling and OI is falling, the market is WEAKLY BEARISH.

 

Description

If PRICE is falling and OI is falling, it means that the fall in price is due to LONG COVERING or also called LONG UNWINDING. See why is OI falling? It’s falling because positions are being squared off and the number of open contracts in the market is reducing.

But since PRICE is falling with it, it means that LONGS are SQUARING OFF & dominating SHORTS in the transaction. See, how would LONGS square off? They will square off by SELLING. That is why PRICE is falling.

So, PRICE is not falling because SHORTS are dominating and creating new positions. It is falling because LONGS are dominating the squaring off process. Thus, it can not be called BEARISH. It is WEAKLY BEARISH. It can be a TRAP for new SHORTS.

 

Difference between Open Interest and Volume

Just remember that volume is number of contracts traded and open interest is number of outstanding contracts which are not squared off.

Also, remember that volume is measured daily and OI gets accumulated. Now, we’d understand the concept of open interest by creating an example:

 

Open Interest Calculation Example

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Assume that a new futures contract is out of transactions for December expiry. All these transactions are happening in a single session.

Initial counters
Volume: 0
Open Interest:0

Transaction 1: James gets LONG 1 future contract which John SHORTED
Open interest: 1
Volume:1

Transaction 2: Robert gets LONG 1 future contract which Mark SHORTED
Open Interest: 2
Volume 2

Transaction 3: Michael gets LONG 5 future contracts which Matthew SHORTED
Open Interest: 7
Volume: 7

Transaction 4: William gets LONG 10 future contracts which Daniel Shorted
Open Interest: 17
Volume: 17

Transaction 5: David gets LONG 1 Future contract while Robert sells.
Open Interest: 17
Volume: 18

Transaction 6: John gets LONG one contract which David sells.
OI: 16
Volume: 19

 

Important Points to Note:

 

1) Till transaction 4, everything is smooth as new contracts are being created so open interest and volume, both are rising.

 

2) In transaction 5, you can see that the volume increased but OI stayed the same. Volume increased because a trade of a contract happened. But OI stayed the same because no new contract was opened. David got LONG on the same contract which Robert carried. Robert squared his LONGS off by selling and David bought it by going LONG. So the LONG position holder just got replaced in the contract but no new contract was made so OI remains same.

 

3) In transaction 6, you can see that the volume increased but OI decreased. You must have understood the reason as to why Volume got increased. But the reason that OI decreased is that John who was an existing SHORT, squared off the contract by getting LONG while on the sell side is David who is an existed LONG and squared off by going SHORT. So, one old LONG and one old SHORT closed their positions. Thus, one contract got closed and OI reduced by 1.

 

4) Bottom line is that each trade completed on the exchange has an impact upon the level of open interest for that day.

 

5) If both traders are initiating a new position (one new buyer and one new seller), open interest will increase by one contract.

 

6) If both traders are closing an existing or old position (one old buyer and one old seller) open interest will decline by one contract.

 

7) The third and final possibility is one old trader passing off his position to a new trader ( one old buyer sells to one new buyer or vice versa). In this case, the open interest will not change.

 

Open Interest & Breakout

 

In futures. the early stage of a trend, post a range breakout, is not driven by trend followers but by those who are caught on the wrong foot and are forced to liquidate their positions in the direction of the trend. The more traders caught on the wrong side (gauged by open interest before breakout), the more furious the move post-breakout.

Another way to say this would be, if open interest rises during a range bound action, the move post breakout (any direction) will be fierce. Therefore, if the open interest dips at the beginning of a new trend, there is nothing to worry. It’s basically losers covering their positions.

Let’s say the price is moving in a range for 6 months and you see that Ol has started rising heavily. The price is still in the range. So, let’s say average OI during the range was 1 lac and in the past week it has become 5 lac but the price is still in the range. It means that new positions have been created but no one dominated each other. Buying and selling pressure is in balance (that’s why the price is still in range).

Now. how would you see the figure of 5 lac? See it as there are 5 lac long side speculators and 5 lac short-side speculators (for every one long there must be one short).

So, now imagine that price breaks out on the upside. You have 5 lac short-side speculators in a panic who will rush to cover and fuel the rally. So, even before long side guys fuel the rally, the rally is promoted with short side speculators who are covering their shorts.

Once the uptrend is in place, then come the trend followers who make new contracts on the long side. That is why we may see OI falling on breakout sometimes. That is because old short contracts are being covered.

Think about the other case that price breaks down on the lower side, 5 lac long speculators are in panic and unwinding longs and promoting the downside further and it picks up speed. the new short side speculators also enter and further drag the price.

The more the OI in the range. the more the panic by those who are at the wrong side of the trade and the more the explosion in the direction of the breakout.

 

 

Conclusion: Open Interest Analysis

This is all for this time. Hope you enjoyed reading the post and understood clearly the difference between open interest and volume as well as the open interest calculation example.

Comments are appreciated, do share your thoughts on this.

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