Unlocking the Potential of Open Interest: A Guide

In the dynamic world of stocks, where trends come and go like fleeting whispers in the wind, one data have stood the test of time: Open Interest (OI). I often encounter questions like, Is Open Interest still relevant in 2024? or How does Open Interest trading strategy really work?

Recently, a follower reached out to me on Instagram with a similar inquiry. He was perplexed about the implications and significance of Open Interest in both futures and options trading. This led me to ponder deeply on the subject, realizing the need to provide clarity not only to the individual who reached out but to anyone else navigating the complexities of Open Interest.

Open Interest Trading Strategy

Thus, I embarked on the journey to demystify the enigma surrounding OI. In this comprehensive guide, I aim to delve into the intricacies of Open Interest, elucidating its relevance in 2024 and beyond.

Before we delve into the intricacies of various conditions related to open interest, let's first establish a clear understanding of what open interest actually entails.

What is Open Interest?

Open interest is a fundamental concept within the realm of Futures and Options (FNO) trading. It comes into existence when a new contract is initiated in the FNO market. For every contract bought by a buyer, there must be a corresponding contract sold by a seller.

Thus, when both parties agree to the terms of a contract – a buyer agreeing to buy and a seller agreeing to sell – an open interest is generated. In essence, open interest reflects the number of outstanding contracts in the market at any given time, serving as a key indicator of market activity and sentiment.

When does Open Interest Close?

For Open Interest to be considered closed, a contract must undergo a full buy and sell cycle. What does this entail? When a buyer purchases a contract and holds onto it without selling, the contract remains open and contributes to the open interest tally. However, when the same buyer finds a seller and sells the contract, the contract is closed, and consequently, so is the open interest associated with it. It's crucial to grasp that when a buyer completes both the purchase and sale of the same contract, the loop is closed, and the open interest is considered closed as well.

On the other hand, for a seller to close an open interest, they must complete a sell and buy cycle. This distinction forms the delicate boundary between open interest and volume. Put simply, closed open interests are regarded as part of the volume.

General Interpretation of Open Interest

Open Interest is a crucial metric that provides hidden insights for traders. Here it goes:

Increasing Open Interest

Increasing open interest signals a influx of fresh capital entering the market, hinting at the reinforcement of the prevailing trend. This is typically viewed as bullish, signifying that traders are increasingly engaging in the market with long positions during an uptrend.

Conversely, in a downtrend, this can be seen as bearish, with new capital joining the market through short positions. Essentially, it amplifies the existing trend.

Decreasing Open Interest

A decrease in open interest indicates traders are closing out their long positions or offsetting their short positions, signaling diminishing interest in the market. This could hint at potential reversals in the prevailing trend.

Unchanged Open Interest

Aside from uptrends and downtrends, another market trend known as sideways or consolidation exists. During this phase, open interest typically remains unchanged. This occurs because buying and selling interests appear to be in equilibrium, indicating a lack of conviction in the market from both buyers and sellers.

Active Open Interest at Support and Resistance

When substantial changes in open interest or spurts in OI are observed around a critical support or resistance level, it could suggest a potential reversal. However, this isn't always the case as when a stock approaches a resistance level during an uptrend, significant OI might signal a potential breakthrough of that resistance. Similarly, this scenario could be beneficial for stocks in a downtrend when nearing a support level.

Indeed, when stocks are in a consolidation phase and approach critical support or resistance levels, it may indicate a forthcoming reversal.

Advantages of Open Interest

Open Interest serves as an excellent indicator of market sentiment. Utilizing it can certainly give you an edge in the trading arena. Here are some benefits of OI:

Assessing Market Strength

Open Interest helps you identify the trend of stocks and serves as a valuable tool in gauging the actual strength of the trend, aiding you in making informed decisions.

Trend Reversal

When combined with price movements, Open Interest provides signals for potential trend reversals.

Risk Management

Using OI as a tool provides essential details that can assist you in managing your risk effectively right from the start.

Where Can We Find Open Interest?

Open interest is created when you trade any contract (buy or sell contracts) in futures and options (F&O) trading. This means open interest can be generated in both futures and options trading.

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Is Open Interest Generated in Cash Trading?

Open interest is not generated in cash trading. In cash trading, actual stocks are traded instead of contracts, so it only creates volume. In F&O, as discussed earlier, open interest is generated, and closed open interest ultimately contributes to volume. Unlike cash trading, F&O markets have both open interest and volume.

Relation Between OI and Price

There exists a significant relationship between open interest and price movements. When these two data points are combined, they reveal invaluable insights into gauging the trend, identifying trend reversals, and pinpointing consolidation phases of a stock. This fusion creates dynamic patterns known as OI Build Ups. In the realm of futures and options (FNO), you will consistently encounter one of these four build ups: Short Build Ups, Long Build Ups, Long Unwinding, and Short Covering.

Apart from trend identification, the practical application of these OI Build Ups lies in selecting momentum stocks and trading them. Thus, open interest can serve as a comprehensive tool to discover momentum stocks, trends, and also assist in making informed decisions regarding entry, exit, and risk management.

Long Build Ups

A Long Build Up happens when the price rises alongside Open Interest. This suggests an uptrend in the stock, reflecting bullish sentiment and strong price momentum. This suggests that buyers are entering the system with full force.

Sort Build Ups

Short Build Ups happen when Open Interest rises while prices fall. This indicates a strong bearish trend, with prices showing clear weakness. This opens the door for sellers to take the lead.

Short Covering

It occurs in the market when prices increase but Open Interest decreases due to the closure of contracts. This indicates a mild bullish sentiment, although not as strong as Long Build Ups, which typically occur in downtrends. Prolonged short covering could signal a trend reversal. Short covering is a signal that sellers who were in control for a while are now exiting the market.

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Long Unwinding

When both Open Interest and Price decrease, it's referred to as Long Unwinding. When this happens, we observe weakness in price, but it's not as pronounced as with short build ups. Long Unwinding indicates that buyers are exiting the market.

How Open Interest Works

As we discussed, Open Interest is generated in both Future and Option Trading. While the general understanding of Open Interest and its components remains the same for both Futures and Options, there are some fundamental differences in their application. Let me explain them one by one. I'll start by explaining how Open Interest works with Options and then cover the same for Futures.

Application of Open Interest in Option Trading

In option trading, Open Interest is generated and can be observed on the Option Chain. There are two columns on any Option Chain, You can refer to this beginner's guide on Option Chain, dedicated to Open Interest, namely Open Interest and Change in Open Interest. Let's understand each one.

Nifty Option Chain

Open Interest on Option Chain

In the above Option Chain, you can see two columns of Open Interest (OI), one on the put side and the other on the call side. We consider all Open Interest on the call side as creating different levels of resistance with varying strength. The strike prices indicate the levels at which OI is creating resistance.

For example, at strike price 22,500, we have 161,843 lots of Open Interest, and at strike price 22,800, we have 278,895 lots of Open Interest. Both of these create resistance, but with different strength. The beauty of resistance found in Option Chain is that you can compare their strengths. By comparing these two strikes, you can conclude that Nifty has stronger resistance at 22,800. Similarly, you can compare any strike and their respective strengths.

What about support? Similarly, we can identify support by examining open interest on the put side. Open Interest on the put side provides different levels of support with varying strength. Strikes represent the levels at which Open Interest is creating support. You can compare the strength of support just as you did with resistance.

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For example, at Strike 22,500, there are 145,976 lots of Open Interest, while at Strike 22,400, there are 96,293 lots of OI. Comparing these two strikes, you can conclude that 22,500 has stronger support than 22,400.

Varying levels of open interest indicate the probability of either support or resistance being broken. For example, the strike with the highest open interest has the lowest probability of being broken, while the strike with low open interest has a higher probability of breaking.

Change in Open Interest on Option Chain

The Support and Resistance obtained from the option chain are termed Dynamic Support and Resistance (I do). Why? Because the levels and strength of these support and resistance continuously change, all thanks to Change in open interest. Open interest has the ability to shift both resistance and support levels, as well as alter their strength.

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For instance, consider the strike of 22,600 on the call side. 117,621 lots of open interest were added to the tracked Open Interest in the Change in OI column. This means that the resistance at 22,600 has its strength increased. Simply put, at the start of the day, 22,600 had only 54,729 lots of Open Interest, which by the end of the day became 172,350 lots because 117,621 lots OI were added into the Change in OI.

Similarly, you can observe that the support at the strike of 22,700 weakened as 49,766 lots of open interest were removed from the system.

So, Open Interest creates Support and Resistance, and Change in OI makes them dynamic. Careful observation of Change in OI can provide insights into whether a particular support or resistance is likely to be broken or not.

So far, we've covered everything about open interest and option chain from the perspective of option writers. You can delve deeper and identify buyers and sellers on the Option Chain.

OI Build Ups on Option Chain and their Implications

Option traders have two ways to trade options: by buying or by writing them. Similarly, if you want to take a bullish position in the market, options offer two approaches. You can go long by buying call options or by selling put options. In option trading, writing and selling are used interchangeably. Conversely, if you are bearish, you can buy put options or write call options. It's important to note that both calls and puts can be bought or sold.

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Here's the catch: OI build-ups help you identify option buyers or sellers. Once you identify them, here are the conclusions you can draw from these build-ups:

  • Long Build Ups in Call + Long Unwinding in Put = Bullish Market
  • Short Build Ups in Put + Short Covering in Call = Bullish Market
  • Long Build Ups in Call + Short Build Ups in Put = Super Bullish Market
  • Long Build Ups in Put + Short Build Ups in Call = Super Bearish Market
  • Long Build Ups in Put + Long Unwinding in Call = Bearish Market
  • Short Build Ups in Call + Short Covering in Put = Bearish Market

Apart from these combinations of OI build-ups on the Option Chain, the market remains sideways.

Future Open Interest Data

In futures trading, unlike options, you only have one Open Interest and one Change in Open Interest data. Since futures don't have classifications like call or put, it's relatively easier to understand open interest and its implications here. In fact, all the general discussions about open interest we had in the entire article were simply related to futures trading.

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Future OI Build UPs and Trends

Expanding on the previous discussions, Long build ups generally indicate a bullish trend, whereas long unwinding suggests that the bullish momentum is gradually diminishing. Short build-ups indicate market weakness, while short covering suggests that this weakness might temporarily halt.

I trust this article has enhanced your understanding of Open Interest and its application. However, you might still be pondering which OI data to utilize in your trading: Future OI data or Option OI data. Different trading strategies can be developed using either Option Open Interest or Future OI. 

Alternatively, you can combine these datasets for a more comprehensive view of the market. You can employ future open interest data and Build Ups to select stocks and execute trades. Similarly, you can use Option Open Interest and OI Builds to identify trends and trade the market.

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