Lessons from the Pros

India Markets

Open Interest as an Odds Enhancer

Open interest is reported on TV daily in relationship to F&O but many people still misunderstand it and how it can be beneficial to you as a trader.

The first thing to realize is that open interest is not volume.  Volume refers to the number of contracts that have been traded on that particular day.  This number always starts at zero at the start of the trading day and moves up with every contract traded.  Open interest is the sum of all contracts that are currently open and have not been offset by another position.

In share trading, a company issues a certain number of shares that can then be sold and traded.  With futures, there are not the same limitations on the number of contracts traded.  If I want to open a new long position in the Nifty Futures, I buy a contract from a seller who may be writing that contract.  The contract never existed before and with them writing it and my purchase of the contract, volume would increase by one and now open interest would increase by one to reflect the creation of that contract.

Volume can still rise while open interest remains unchanged or drops.  Suppose that after buying that contract, I decided to sell it for a profit or a loss.  If I sell my contract to someone else, I am transferring ownership of that contract.  Volume would go up by one but open interest would not change as I did not create a new contract.

Imagine now that I am selling that same contract, but instead of selling it to someone who is opening a new position, the buyer was closing their short position in the Nifty futures.  I am closing a position and so is the buyer.  Volume would still increase by one to record the transaction, but the open interest would decrease by one to show that we both closed out our contracts.

Open interest can give us clues to the strength or weakness of a trend.  If you are approaching a supply or demand level and expect prices to reverse, check to see if open interest is confirming that possibility.  When open interest decreases, it is taken as a sign of trend weakness and potential trend reversal.  However if open interest is rising in the trend, often you will notice that trend continues and will break those supply and demand zones.  This will help you hold positions longer and see greater profits.

oi chart

You can watch the open interest in the trade tiger platform or see the changes in the open interest on the exchanges’ websites.  When you see open interest changing near supply and/or demand zones, treat it like an odds enhancer to help make your decision to buy or sell.

nifty future oi

The same technique can be used for trading in the commodity markets.  Looking at open interest and a chart of copper futures, when open interest declined, it was a warning sign of trend reversal and a timely exit of longs.

oi copper

Additionally, the open interest and volume can be combined to filter out commodities that may not be suitable for intraday trading.  In trading equities, we want to stick with stocks that offer good liquidity so that entering and exiting trades is easier.  I tell my students to stay with a minimum of five lakh shares traded per day on average.  But with commodities that is a bit different.  We may not have that many contracts traded per day.   As long as the daily volume is higher than the open interest on average every day, you should not have a problem trading that commodity intraday.  If the volume is lower than open interest every day, then you may want to only trade that commodity on a longer term basis.

bwendell 20131022 - volume vs oi

Keep an eye on open interest when you are trading any type of futures contracts.  Knowing how it affects the trend and price of your security is important to you achieving success in trading.

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