What is Open Interest (OI)? How to interpret it?

Open Interest refers to the total number of futures or options contracts currently open – not settled or closed – in the market. It’s a measure of the flow of money into the options market.

In the stock market, most people think of the bid and ask price when they imagine the stock market. However, there is a lot more to the stock market than that.

Understand the open interest: Open Interest (OI) is one of the most popular terms among stock traders. In this article, we will look at what exactly an open interest is. Here, we discuss its definition, what an increase or decrease in open interest means, the difference between open interest and volume, and how it should be interpreted.

Let’s get started.

Determination of open interest

Open interest is the total number of futures contracts (or options) held by market participants at any time. The total number of open interest contracts changes with each transaction executed. Open interest is considered the best indicator to assess market sentiment and understand the reliability of price movements.

So, to have an open interest, there must be a buyer for every seller and vice versa. Here, the relationship between buyer and seller creates an open interest. Thus, when buyers and sellers combine and take a new position, the open interest increases by one. And when those same buyers and sellers unwind their positions, open interest falls.

But when the buyer and seller transfer their position to the new buyer and seller, the open interest remains unchanged; it is simply a position transfer.

Why is Open Interest Important?

1. Liquidity Indicator: Higher open interest means more liquidity, making entering or exiting positions at competitive market prices easier.
2. Market Sentiment: An increase in open interest, coupled with a price increase, often confirms a current trend. For example, rising open interest in call options alongside rising stock prices is typically bullish.
3. Predictive Indicator: Some traders analyze open interest patterns to predict price movements. However, this should be done with caution and in conjunction with other indicators.

Difference between open interest (OI) and volume

It is a common misconception that OI – Open Interest and volumes mean the same thing. However, these are two different concepts that produce two different data sets. However, both data can be used in combination. Let’s understand the concept of open interest with an example.

Here is an explanation of the difference between open interest and volume in the context of Indian stock market futures contracts, using Nifty futures as an example:

Open Interest refers to the total number of outstanding futures contracts that have not been settled. For example, if there are currently 500,000 Nifty futures contracts that are still open – that is, traders have opened these contracts but have not closed out of them – then the open interest on Nifty futures is 500,000 contracts. This number will change daily as some traders open new contracts while others close out existing positions.

Volume refers to the number of Nifty futures contracts that are traded in a given period of time (usually a trading day). For example, if 300,000 Nifty futures contracts were traded today, then the trading volume on Nifty futures today is 300,000 contracts. Volume reflects the actual buying and selling activity happening during the day. The same Nifty futures contract may be bought and sold many times a day, contributing to trading volume each time.

So, in summary – open interest reflects the total open contracts at any given time, while volume indicates the daily trading activity as traders open and close positions. Even if volume is high on a given day but more traders were opening new contracts than closing existing ones, open interest would rise for that day. The two metrics provide different insights into futures trading activity.

Open interest data (Moneycontrol.com)

In the snapshot above (Figure 1), we see the data showing the action with the Index futures in open interest for the day.

Interpretation of open interest and volume

From the above discussion, it is clear that the IO gives us information about the open contracts and the market. But volume tells us how many transactions took place in the market.

The volume data resets at the end of the day, and a new counter starts at the beginning of the next day, but the OI data is a continuation of the previous day. 10 lots purchased and 10 lots traded equals 20 as trading volume and 10 OIs for the day.

Interpretation of Change in Open Interest

1. Increasing open interest and rising index prices generally indicate a bullish market sentiment. This means new buyers are entering the market and opening up new long positions in index futures, anticipating prices will go up further. This points to bullishness.
2. Decreasing open interest along with falling index prices indicates bears are in control and existing buyers are exiting positions, closing out long contracts. This reduction in open positions signals bearishness.
3. An increase in open interest and a fall in prices suggest fresh shorts are being built up as new traders take bearish positions. So, the market is turning increasingly bearish here.
4. If open interest remains stable or unchanged even as index prices increase or decrease, it indicates market sentiment is neutral. If they are not changing positions, existing market participants likely don’t have a strong bullish or bearish bias. The rise or fall in prices is likely short-term and is not affecting overall sentiment on either side.

So, to summarize – a simultaneous rise or fall in prices & open interest shows a bias in sentiment. In contrast, market sentiment remains neutral without a clear directional consensus when price changes do not alter open interest.

Supplement

In this article, we have tried to simplify the concept of open interest in the stock market and explain what it stands for. Here are some important points to remember from this article:

• The open interest gives you information about the total number of contracts traded on the market.
• This is an excellent indicator of understanding market sentiment and expected market dynamics.
• When a contract changes hands, it is only a transfer of position, and the open interest does not change.
• Volume data is updated daily, but open interest is continuous data.

So much for this post. I hope this was helpful. If you have any more questions about the open interest in the stock market, please comment below. I want to help you. Good business.

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