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How to use Open Interest for Trading

Many queries,  I am getting about Open Interest such as what is Open Interest? How does it work? How does one take entry and exit based on it? What are the meanings of change in open interest? And many more.

Let's understand Open interest (OI) first, later we will delve into its practical impacts and uses of OI.

Understanding Open Interest

When you buy a derivative (Option or Future) contract, but you don’t sell it. This condition creates one open interest. Say, you bought one lot of Nifty Future contracts, you create an open interest. This contract is yet to close, so open in the market. As long as you are interested to hold the contract, it will remain open and called to be an open interest.

Thus, the term open interest signifies several derivative contracts open in the market. A contract is open if it is Bought only or Sold only. That is you have Bought a contract but have not sold it. You can also sell a contract but not buy it. In both conditions contract is open and open interest increases. The contract is closed if it is bought and sold both. So open interest at a time shows a number of contracts open or sold at a given time.

The Future contract that you are holding, you sell it in the market. The time you sold it, you closed a contract and this condition is said to be a contract is close and open interest decrease by one.

Open Interest can be created in both Option as well as Future contracts of an Index or Stock. When open interest created in Option, it is added to the option chain of the particular scrip. The open interest created in options plays a big role in driving the market as 82 to 85 per cent of the volume in the market comes from option segment. So, this is huge indeed. Once you understand the sentiment of the option players, you can be near to understand the sentiment of the entire market.

All the contracts that are open on the options chain, considered to be option sellers as the big players resort option selling for hedging their position.

So, Call sellers create resistance while put sellers create support. Whatever, we see open interest on option chain can be considered as support or resistance. You might be thinking, you can get the very same support and resistance on the technical charts, why should I worry about another support and resistance?

The difference between your conventional support and resistance and Open Interest is little but create a significant impact as you can identify the intensity of each support and resistance on OI and Change in OI which is unavailable on the traditional.

Let understand it with an example.

Consider this OI Position in Nifty.

Carefully, look at the strike price 8400, 8450 8500, 8550, and 8600. Now Take, 8500,
Strike 8500
Call Writer = 10.79 lakh (Resistance), for simplification I am taking it as 10 lakh. 
Put Writers = 11 lakh (Support)

Now Consider, 10 lakh people are fighting with 11 lakh people. What do you think this fight will go onesided? No, as the number is very close to each other, they will give hardness to each other. However, in the first glance, 11 lakh looks stronger. The fight goes on for 10 minutes and surprisingly, the put writers started increasing and they become 12 lakh then 13 lakh and this increment goes on. The game is changed now totally. It means the put writers are increasing and this indicates, they will win the battle. So, opposition has two options either slain themselves or escape. But they choose to escape from there. If you get such situations, you will get a flood gate open for you.

Consider the second scenario, Put writers are increasing in exactly the same way as they did above, but call writers are not escaping from that strike or escaping in extremely little number. This indicates put writers are winning the game, but call writers won't let them win for the much time. They will turn the game in their favour in some time. To bring the ball, in their favour, they will use the strike 8600 and 8700 because they have some people to support them. They will start making position at these strikes. Once, the position becomes quite high, then we see the ball start rolling in their way.

This type of game always goes on between bulls and bears and they make themself strong by making position in OI. If the position shifted one strike to other strikes, it means a move in that direction is coming. So, you have to keep eyes on position shifting in OI. This position shifting can be checked in by watching the change in OI.

The level such as 8500 where bulls and bears are in almost equal number is known as the pivot level.

One thing, I want to mention here at pivot levels, bulls and bears always take time to decide the direction, once they decide the direction a mighty move comes.

The Open Interest positions create the resistance and support, it also supplies an instruments, change in OI, with the help of that we can gauge the magnitude of that resistance or support. You can spot the smallest leakage from resistance or support if you look at them carefully.

Now, If you compare these two images, the first image convey call writers are stronger, but you check the second image that says though call writers are stronger at 8500 but put writers are increasing their position slowly. This indicates a move might be in the way upside. Now this image, also check Nifty Fut price, date and time above the image.

Open interest is a dynamic tool, so you have to check it at a regular interval. In other words, these are the dynamic resistance and support.

Can you take entry basis of this?
Yes, you can take entry based on OI and change in OI. Always look for pivot level in any index or stock. See, these levels are dynamic so pivot levels keep changing, in image 3, the pivot level is 8600 now, as pivot level shifted up you have witnessed an up move.

Stop Loss

Once you are confirmed with the market direction, then you can keep your SL just above or below the pivot level. If you follow OI religiously, you will find 10 or 20 points SL is enough in Nifty. You might also keep SL in mind.

Profit Booking

Always try to book your profit, at second pivot levels. you might carry your position with trailing stop loss.

No lunch is free. Same ways, there is nothing easy in the market. You have to put your effort in it to become the pro of this game. 

Hope I have made it little easy for you to understand the practical use of OI. Ask any question in the comment box if you got any query.

How to use Open Interest for Trading Reviewed by Kumar Chandan on March 31, 2020 Rating: 5

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