What is Open Interest?

One of the most popular and widely used words in the lexicon of F&O trading is open interest. As the name suggests, open interest represents the open futures and options positions in the market that are yet to be closed out or exercised, or expired. Open interest is an important metric as it gives you an idea of the positions that are standing in the market gives an idea of the drift of the market outside of the normally speculative transactions.

Here we look in detail at what is open interest in the stock market with a focus on futures open interest and options open interest. Remember, that open interest gets created in options and futures. Apart from looking at what is open interest in options, we also look at the idea of what open interest is in share markets in the Indian context. Here is a quick take on open interest and its practical applications.

About Open Interest?

Futures and options have emerged as a key instrument in Indian capital markets in the last 10 years. Today, futures and options account for over 90% of the daily volumes on the NSE. Since futures and options are contracts, you will find contracts that are constantly being opened and closed. How do you distinguish positions that are closed speculatively from positions that are held on for some time? This is captured by the idea of open interest.

What exactly is this idea of open interest? If you study the open interest and juxtapose it with the stock price, then you can get some unique insights into trends and the accumulation in the stock. It is a lot more interesting to understand how this open interest gets created, sustained, enhanced, and finally extinguished. Let us look at what is open interest in the stock market how an increase in open interest and decrease in price means?

Open interest process flow; how it gets created and unwound?

You can understand the open interest in futures and options as the equivalent of delivery in the cash market wherein you plan to hold on for a longer period. Open interest or simply OI refers to all the contractual futures and options positions that are still open. How does this open interest get created? Simply put, if you buy 10 lots of nifty, someone has sold 10 lots. Effectively 10 lots of open interest are created. Now if C buys 10 lots and D sells the 10 lots, then you have 20 lots as market open interest. That is how the process goes on.

At a very simple level, when you buy a lot of Nifty and another person sells a lot of Nifty then the OI created is 1 lot. If there are only two traders in the market then unwinding the above position will bring OI back to zero. But the real world is never as simple as the idea world and hence we need to factor in complications. On the other hand, if any fresh OI is being met with unwinding by existing holders, then the OI remains the same. In the real market, new buyers and new sellers keep getting added to the market and that is what leads to the creation of new open interest on stock and an increase in open interest. At any point in time, there is the creation of open interest and closure of open interest at the same time. The final open interest is the total of all these pulls and pushes.

The best way to understand open interest is to look at a very simple example. Let us look at 3 days of F&O trading and how the OI creation and enhancements happen over the 3 days. We will also see how the specific OI gets extinguished.

Monday: A buys 1 lot of Nifty Futures and B sells 1 lot of Nifty Futures. What is the outcome? This will result in a market OI of 1 lot of Nifty; we avoid double counting. If both A & B reverse their positions then the OI of the Nifty will be back to zero, but let us not jump the gun.

Tuesday: A buys 1 lot of Nifty Futures and B sells 1 lot of futures, creating a market OI of 1 lot. The next day, A sells his 1 lot to C. The OI of the Nifty remains at 1 lot as only 1 party is replaced with another party. Overall OI remains the same.

Wednesday: A buys 1 lot of Nifty Futures and B sells 1 lot. At the same C buys 1 lot of Nifty futures and D sells 1 lot. On the same day, E buys 8 lots of Nifty Futures and F sells 8 lots. In this case, the total OI of the Nifty Futures will be 10 lots. OI expands when lateral trades expand.

What are the key takeaways from this example? In a nutshell, the OI of the Nifty will expand as new participants keep initiating fresh positions in the Nifty or in any other stock. This logic will apply to options and futures also. As long as customers are just being replaced, the OI will remain constant. However, as traders start unwinding positions, the OI starts dwindling gradually.

To recap, look at OI as the equivalent of the delivery in the equity markets. They are positions held for the long term against speculative positions that get closed at short notice. They give important indicators about the direction of the market.

How to interpret the shifts in open interest or OI

Open interest by itself may not be too indicative or suggestive. However, shifts in open interest typically happen over time and hence such medium to long-term trends are more suggestive. Here is what you need to know about shifts in open interest.

• OI shifts give interesting clues for the traders and investors to take positions inequities. At least, it acts as a ratifying factor if not as a deciding factor.
• OI acts as a lead indicator of long or short interest building up in stock. This is normally quite evident when you combine the same with volumes and price moves.
• Expanding OI indicates widening of the contract exposure and is a safety signal. It gives a degree of comfort that a speculative bubble is not here to bite into your profits.
• OI gives a clear indication of stocks bottoming out or stock prices topping out. That is because any major turnaround in the stock, either on the positive side or the negative side is preceded by open interest or OI shifts.

Open interest or OI interpretation; How does it all add up?

OI should never be looked at in isolation but it should be looked at about the movements in the stock price and also the volumes. That can give some interesting insights into future price movements of the stock. Here are four analytical points for you to know.

• Rising Open Interest with steadily rising stock prices is normally considered to be a healthy and positive signal for future price movements. It indicates that investors are getting interested in the stock and there is also distribution of ownership. Normally, this is indicative of a likely rally in the stock, although the extent is not too clear.
• If the open interest or OI of the stock is falling but the stock price is increasing, it is signaling a lack of conviction. It is typically indicative of a stock rally is being driven by short covering. Shorts typically cover when they have booked profits. Any rise in price in such cases is temporary and not sustainable and traders need to position accordingly.
• Rising OI with falling stock price is not at all a good sign for the long traders at least. Here is why. It is indicative of fresh short positions being built up in the stock and it means there are sufficient people bearish on the stock. Normally, heavy shorting is indicative of a sharp correction ahead, especially if accompanied by rising volumes too.
• If the OI is falling supported by a fall in price, it could have two interpretations. This is a sign of long positions being unwound in the market, which could mean that upsides are limited and the undertone is weak. But there could also be a positive side to it. The stock is becoming light in terms of F&O leverage and that means the froth is going out of the stock. While this is not directionally indicative, it hints at stock becoming more predictable in the future.

Remember, these are just indicative interpretations and you have to rework this interpretation by considering more variables like spot price, volumes, news flows, etc. What matters is that OI is an important data point for F&O traders and equity investors too.

How to calculate open interest?

Calculation of open interest is dependent on whether you are looking to calculate the open interest of a stock or a contract. It is the total of all positions that are open in futures and options. Once positions are closed, they cease to be open interest.

Open interest vs. Trading volume

Normally, trading volumes in futures and options are compared to open interest to understand whether the volumes are resulting in the actual creation of fresh OI or not. If the volumes are high but OI is not building, it means that there is too much speculative activity in the F&O market with an inadequate focus on building OI positions.