Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2023-10-25T17:40:52+05:30
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Introduction

Open Interest (OI) is a crucial concept in the world of futures and options trading. A futures contract binds the buyer to buy and the seller to sell and deliver a certain asset at a predetermined future date. An option allows the buyer the choice to purchase (or sell) an asset at a predetermined price at any point during the term of the contract, but it does not obligate them to do so.

Open Interest represents the total number of contracts that are currently held by market participants and have not yet been offset by closing trades. Unlike trading volume, which measures the number of contracts traded during a specific period, open interest focuses on the total number of contracts that are still "open" or outstanding.

Open Interest (OI) is a metric that quantifies the total number of futures or options contracts actively in circulation within the market. It's important to note that every trade involves two parties: a buyer and a seller. For instance, when a seller offers and a buyer acquires a single contract, the buyer holds a long position in that contract, while the seller takes a short position. In this scenario, the open interest is recorded as 1, signifying the existence of an active contract on the market.

To illustrate this concept, let's consider an example:

Example:

Imagine you are observing the futures market for gold contracts. Each gold futures contract represents the obligation to buy or sell a specific amount of gold at a predetermined price and date in the future. In this example, we'll focus on the open interest for gold futures contracts.

Day 1:

Morning: The gold futures market starts the day with zero open interest.

Trader X decides to buy 5 gold futures contracts, and Trader Y simultaneously decides to sell 5 gold futures contracts. This means Trader X is now "long" 5 contracts, and Trader Y is now "short" 5 contracts.
Calculations at the end of Day 1:

Open Interest: 5 contracts (because there are 5 contracts that are still open, as Trader X and Trader Y have not offset their positions).

Trading Volume for the day: 10 contracts (5 bought by Trader X and 5 sold by Trader Y ).

Day 1

     
Trader Buy  Sell Contracts held
X 5   5
Y   5 5
Z      

OI

    5

Day 2:

Morning: The market opens with an open interest of 5 contracts (carryover from Day 1) and a trading volume of zero.

Trader Z enters the market and buys 10 gold futures contracts.

Calculations at the end of Day 2:

Open Interest: 15 contracts (5 from Day 1 + 10 bought by Trader Z).

Trading Volume for the day: 10 contracts (all bought by Trader Z).

Day 1

      Day 2    
Trader Buy  Sell Contracts held Buy Sell Contracts held
X 5   5      
Y   5 5      
Z       10   10
OI     5    

15


Day 3:

Morning: The market opens with an open interest of 15 contracts (carryover from Day 2) and a trading volume of zero.

Trader W decided to sell 7 gold futures contracts.

Calculations at the end of Day 3:

Open Interest: 22 contracts (15 from Day 2 +7) sold by Trader W).

Trading Volume for the day: 7 contracts (all sold by Trader W).

Day 1

      Day 2     Day 2    
Trader Buy  Sell Contracts held Buy  Sell Contracts held Buy  Sell Contracts held
X

5

 

5

           
Y  

5

5

 

         
Z      

10

 

10

     
W               7 7
OI     5     15     22

Day 4:

Morning: The market opens with an open interest of 22 contracts (carryover from Day 3) and a trading volume of zero.

No new trades occur during the day; all positions remain unchanged.

Calculations at the end of Day 4:

Open Interest: 22 contracts (no change from the morning since there were no new trades).

Trading Volume for the day: Zero.

Day 1

      Day 2     Day 3     Day 4    
Trader Buy  Sell Contracts held Buy  Sell Contracts held Buy  Sell Contracts held Buy  Sell Contracts held
X 5   5                  
Y   5 5                  
Z       10   10            
W               7 7      
OI     5     15     22     22

 

Key Takeaways

Open interest accumulates as new contracts are initiated and decreases when existing contracts are offset or closed.
Trading volume represents the total number of contracts traded in a given time frame (in this example, daily).

Open interest provides insight into the total number of outstanding contracts in the market, while trading volume shows the number of contracts traded during the specified time frame.

Monitoring both open interest and trading volume can help traders and analysts gauge market sentiment and participation.

In practice, traders and analysts use historical open interest and trading volume data alongside price charts to make informed trading decisions and identify potential trends or reversals in the market.

 

Key Points

1. Outstanding Contracts: Open interest reflects the number of outstanding contracts in the market at a given time. It provides insight into the level of participation and interest in a particular futures or options contract.

2. Two Sides to a Trade: Every futures or options trade involves two parties, a buyer (long) and a seller (short). The open interest increases by one contract each time a new trade is initiated.

3. Stays Open Until Offset: A contract remains open until it is offset by an equal and opposite transaction. For example, if Trader A decides to sell the same futures contract they bought earlier, the open interest on that contract would return to zero for that specific trader.

Take a look at the illustration below:

Open Interest in Options?

 

As of 20th October, OI on HDFC Bank futures is roughly 5.35 Crores. It means that there are 5.35 crore Long Nifty positions and 5.35 crore Short Nifty positions. Also, about 1.72 crores (or 47.52% over 2.78Crs) new contracts have been added today.OI is a great tool for figuring out how liquid the market is. The market is more liquid, the larger the open interest. Consequently, it will be simpler to initiate or exit trades at attractive ask/bid rates.
 

Differences Between Open Interest and Trading Volume

While both open interest and trading volume provide valuable information about market activity, they serve different purposes:

1. Open Interest: Reflects the total number of contracts that are currently open and outstanding in the market. It is a lagging indicator, meaning it provides information about existing positions rather than recent trading activity.

2. Trading Volume: Measures the number of contracts traded during a specific time frame, such as a day or a trading session. It is a real-time indicator that shows the level of buying and selling activity in the market.

 

Benefits of Using Open Interest and Trading Volume Data

Understanding open interest and trading volume data can be beneficial for traders and investors in several ways:

1. Market Sentiment: High open interest combined with increasing trading volume may indicate strong market interest and potential price trends. Conversely, declining open interest may suggest waning interest in a contract.

2. Liquidity Assessment: Trading volume helps assess the liquidity of a contract. Contracts with higher trading volumes tend to have narrower bid-ask spreads and lower transaction costs.

3. Confirmation of Trends: Analyzing open interest alongside price movements can help confirm the strength or weakness of a trend. For example, if prices are rising, and open interest is also increasing, it may indicate a sustainable bullish trend.

4. Contrarian Indicators: In some cases, high open interest levels can signal market extremes and potential reversals. Traders may use open interest data as a contrarian indicator when it reaches extreme levels.
 

How do traders use open interest data in their trading strategies?

1. Rising OI and Markets:

Rising open interest and price action during an uptrend are seen as signs of new money entering the market. That shows that the market is bullish, which is bullish.

2. Declining OI and Rising markets:

If price action is increasing while open interest and volume are decreasing, the price rally is being driven by short sellers covering their bets. Money is consequently exiting the market. This is seen as a bearish sign by traders.

3. Rising OI and Falling Markets:

Some traders think new money is entering the market when prices are falling and open interest and volume are increasing. The pattern, in their opinion, points to an aggressive new short-selling strategy. This situation is predicted to result in a downtrend's continuation and a bearish condition.
 

4. Falling OI and Markets:

Last but not least, if open interest and volume are reducing and prices are falling, it is probably because holders of long holdings who are unhappy with the market are being pushed to sell their positions. Because they believe the downtrend will finish once all the sellers have closed their positions, some technicians see this scenario as a solid position.
 

Open Interest Indicators

The following methods will help you maximize Open Interest in intraday trading:

1. Confirming Breakouts: If the Open Interest is increasing in tandem with a stock price breakout from a key resistance level, this is a confirmation of the breakout. Increased Open Interest and a breakthrough point to a greater likelihood of the trend continuing.

2. Divergence Analysis: Look for divergences between price and Open Interest patterns. When the price is hitting higher highs but the Open Interest is falling, it may be an indication that the trend is about to reverse.

3. Options Trading: Monitoring Open Interest is essential for intraday option traders. For particular options contracts, changes in open interest can offer clues as to how smart money is positioned.
 

Conclusion

In conclusion, open interest is a valuable metric for traders and investors to gauge market participation and sentiment in futures and options markets. When used in conjunction with trading volume data, it can provide valuable insights for making informed trading decisions. Monitoring these metrics can help traders identify potential opportunities and risks in the market.

 

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