MECHANISM OF DERIVATIVES PART-III “OPEN INTEREST”

After providing the best possible tutorials in our last two sessions on mechanism of derivatives now we will discuss about some more dynamics of derivatives. Derivatives are either used for hedging or for speculation and if you would like to be an active player in the derivatives market than “open interest" is also an important market indicator that could lead you in the right direction. By definition, Open interest refers to the total number of derivative contracts, like futures and options that have not been settled in the immediately previous time period for a specific underlying security. A large open interest indicates more activity and liquidity for the contract. For each buyer of a futures contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered 'open'.

What is Open Interest?
Every trade in the exchange would have an impact on the open interest for that day. Say, for example, `A' buys one contract of Nifty on Monday while `B' buys two on the same day. Open interest at the end of the day will be three. On Tuesday, while `A' sells his one contract to `C', `B' buys another Nifty contract. The open interest at the end of the day is now four. In other words, if both parties to the trade initiated a new position, it increases the open interest by one contract. But if the traders square off their existing positions, open interest will decrease by the same number of contracts. However, if one of the parties to the transaction squares off his position while the other creates one open interest will remain unchanged. Open interest, thus, mirrors the flow of money into the derivatives market, which makes it a vital indicator of market direction. Here is how you interpret open interest.

Advantage 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

Rising Market with Increase in Open Interest
If the markets are on an uptrend and open interest is also increasing, it is a bullish signal. It implies the entry of new players into the market, which are creating fresh long positions and suggests the flow of extra money into the market.

Rising Market with Decrease in Open Interest
If despite a rise in market, the open interest decreases, it can be interpreted as a precursor to a trend reversal. The lack of additions to open interest shows that the markets are rising on the back of short-sellers covering their existing positions. This also implies that money is flowing out of the market, given that open interest is decreasing.

Falling Market with Increase in Open Interest
When open interest records an increase in value amidst a falling market, it could be a bearish signal. Though a rise in open interest means that new trading positions are being created and fresh money is getting routed into the market, the new money is probably being used for creating fresh short positions, which will lead to a further downtrend.

Falling Market with Decrease in Open Interest
If open interest decreases in a falling market, it can be attributed to the forced squaring-off of long-positions by traders. It, thus, represents a trend reversal, since the downtrend in the market is likely to reverse after the long positions have been squared off. Thus, in a falling market, a declining open interest can be considered a signal indicating the strengthening of the market.

Sideways Market with Increase in Open Interest
When the market is range-bound and there is marked rise in the open interest, we can expect a significant movement in the National Stock Exchange and Bombay Stock Exchange. However, the direction of the move cannot be predicted.

Sideways Market with Decrease in Open Interest
If the open interest decreases in a sideways market, we can say that flat market trends will continue for some more time. A decrease in open interest only represents the squaring-off of old positions and lack of any new positions might result in a sideways or weak trends in the market. Though open interest is a good barometer of where the markets are heading; it is only an indicator that helps us trade intelligently; it cannot be considered foolproof.