Saturday, March 29, 2008

What Is Open Interest?



Everyone out of, yesterday’s hangover????. Okie.. so today I thought, let me put something on Open Interest(OI).I have many a friends who were interested in this(including me ..of course!!!).since I myself am, pretty ignorant about the topic, so decided to seek help from two of my close friends and fellow traders. The credit goes to them for making this post possible. They are Mayuresh(a musik junkie, watches more of rock vids than charts!!!) and Jimmie(OI geek.. swears by it, and the man who got me interested in OI).I have posted a chart on OI by Jimmie…you see when most of us were still tryin2figure out, to be a bull or a bear(2 b or not 2 b!!!) this guy had already taken his stand, based on OI figures. Before I begin, I’d like to tell them “Thank You Guys”. Here it goes….Beware… it might get a bit boring…but then such is the life dearies!!!
What Is Open Interest?
Open Interest is the total number of outstanding contracts that are held by market participants at the end of the day.

It can also be defined as the total number of futures contracts or option contracts that have not yet been exercised (squared off), expired, or fulfilled by delivery.
Open Interest applies primarily to the futures market. Open Interest, or the total number of open contracts on a security, is often used to confirm trends and trend reversals for futures and options contracts.
Open Interest measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract.

Therefore, to determine the total
Open Interest for any given market we need only to know the totals from one side or the other, buyers or sellers, not the sum of both.

The
Open Interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number.
How To Calculate Open Interest?
Each trade completed on the exchange has an impact upon the level of
Open Interest for that day.

For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract.

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

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). In this case the
Open Interest will not change.
Benefits Of Monitoring Open Interest!!!
By monitoring the changes in the
Open Interest figures at the end of each trading day, some conclusions about the day’s activity can be drawn.

Increasing
Open Interest means that new money is flowing into the marketplace. The result will be that the present trend (up, down or sideways) will continue.

Declining
Open Interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. Here having some knowledge of Open Interest can prove useful towards the end of major market moves.

A leveling off of
Open Interest following a sustained price advance, is often an early warning of the end to an up trending or bull market.
Open Interest - A Confirming Indicator???
An increase in
Open Interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in Open Interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while Open Interest remains flat or declining may indicate a possible trend reversal.

The relationship between the prevailing price trend and
Open Interest can be summarized by the following table.
Price
Open Interest
Interpretation
Rising
Rising
Market is Strong
Rising
Falling
Market is Weakening
Falling
Rising
Market is Weak
Falling
Falling
Market is Strengthening

How To Use Puts & Calls As Supports And Resistance???
Taking current level of index, just select the 4 calls and 4 puts from that price & current level put & call. In a way the current spot price acts as pivot. Important thing to keep in mind is select Puts & Calls in multiples of 100s and not in 50s.
For eg. : Suppose nifty spot price is at 4890
Then,
Calls: 4900, 5000,5100,5200,5300
Puts: 4800, 4700,4600,4500,4400
shall be selected.
Now just watch the Open Interest in all these options. In ascending order for calls & descending order for puts. Highest Open Interest in any call shows strong resistance and highest Open Interest in put gives idea about support. Suppose market goes beyond those call or put levels then that resistance converts in support and visa versa.
Put Call Ratio: The put call ratio tells us where market is likely to be active.. Put Call Ratio of 1 suggests neutral, below 1 is bearish, 0.8 is oversold while above 1 is bullish and above 1.25 it is getting overbought.
PCR shall always be good or above 1.25 for shorting.
Rest in terms of Open Interest of options it is same like futures. Similarly you can use Open Interest of futures in conjunction with Puts & Calls. Open Interest is higher in Puts, than Calls, and Open Interest is also increasing in futures, this indicates that market is getting ready for a fall. At that time PCR is definitely higher that 1.25.
Phew this is a long post…any lessons??? Yes…When OI Starts Talking It Pays To Listen!!! As for me I still tryin2figure out OI :)

3 comments:

  1. Hi Manoj,

    Nice post on PCR. We can use PCR at at the extremes as contrary indicator. BTW, pcr above 1 is bearish as more puts than calls, and bullish below 1 - more calls than puts.

    e.g say 1.20 is bearish than 1.15, and 0.55 is bullish than 0.65 etc. But when things go to extreme, it is time for a reversal.

    One more thing - a drawback about pcr is that we will never know whether there are fresh positions being taken or the existing positions are being squared up!

    Nice blog. Keep it up.

    Sunil

    ReplyDelete
  2. Hi sunil
    Thanks for the words of appreciation!!! Anyway I am putting ur comments on the blog so ppl might have the insight oy your views and speaking of views keep em comin chief!!!

    ReplyDelete
  3. Hi !
    It is a very very good information. I m a novice to the stock trading, but m determined to make money out of this. This information can b very use full for me.
    Thx.

    Dharmesh T. Shah

    ReplyDelete