Amazing Insights: How Open Interest Can Wow Your Stock Market Moves

With the growing number of participants in the stock market, not just in India and the US but globally, there is an urgent need for investors and traders to make informed decisions promptly. This is especially important for retail investors, whose investment decisions are often influenced by unreliable tips based on loose sentiments. Therefore, it is crucial to validate these tips using fundamental and technical analysis.

Today, we will discuss using open interest to understand price trends, a topic many traders and investors find challenging. We will explore what open interest is, how it can be used in daily trading, and provide real-time examples to illustrate its application.

Firstly, open interest can be utilized by both equity and futures traders to predict underlying price trends. Although it primarily applies to futures markets, its insights are valuable to all traders. Open interest provides a third dimension to forecasts, complementing price and volume analysis.


What is Open Interest?
Open interest is the total number of outstanding or unliquidated contracts at the end of the day. Each contract involves both a buyer and a seller, who together create the contract. Open interest represents these outstanding contracts held by market participants. An increase or decrease in open interest indicates a corresponding increase or decrease in the number of contracts, reflecting the market's activity.


How change in Open Interest happens?
Every time a trade happens in the market, the open interest is affected in one of three ways: it increases, decreases, or remains unchanged. These scenarios can be summarized in the table below:

Buyer	Seller	Change in Open Interest
Enters new long	Enters new short	Increases
Enters new long	Exits old long	No change
Exits old short	Enters new short	No change
Exits old short	Exits old short	Decreases

Increase in Open Interest: Both the buyer and seller are initiating new contracts, leading to an increase in open interest.

No Change in Open Interest: One party (either the buyer or seller) is entering a new contract while the other is exiting an old position, resulting in no net change in the number of contracts.

Decrease in Open Interest: Both the buyer and seller are exiting their old positions, causing open interest to decrease.

To summarize:
- If both the buyer and seller initiate a new contract, open interest will increase.
- If both the buyer and seller liquidate an old position, open interest will decline.
- If one party initiates a new position while the other liquidates an old position, open interest will remain unchanged.

How to read or analyze change in Open Interest?
Although open interest can be used in isolation with price, analysts usually incorporate volume with open interest to analyze the market. Below is a table that outlines different scenarios and the resulting market moves:

Price	Volume	Open Interest	Market
Increasing	Increasing	Increasing	Continues increasing
Increasing	Declining	Declining	Reversal i.e. market to decline
Declining	Increasing	Increasing	Continues declining
Declining	Declining	Declining	Reversal i.e. market to rise

 

If both open interest and volume increase, it indicates the continuation of the current trend. If both open interest and volume decline, it indicates a reversal of the current trend.

Below is the Nifty 50 daily close price vs Open Interest chart. Nifty 50 is plotted through a line chart of the right axis and Open Interest as a bar chart on the left axis.

In the below chart we can see that the price of Nifty increased from 22700 to 23400 between 31^st May and 3^rd June but Open Interest bar shows light green color i.e. short covering and not long buildup. This indicates the second scenario in the above table. The market declined on the very next day to 22000 with fresh shorts being building up. However, the markets started recovering and we can see short covering on the next day. On 6^th there is strong long buildup i.e. first scenario from the above table. As we can see from the chart that market continues to trend in the upward direction after that.

Courtesy: https://web.sensibull.com/open-interest/fut-oi-vs-time?tradingsymbol=NIFTY

Below is the chart of Bitcoin/TetherUS, we can see that on May 5^th (marked using arrow) the price declined with increasing volume and increasing Open Interest i.e. third scenario from the above table indicating continuation of declining trend and that is what happened in subsequent trading session.

Similarly, we can also see that price on May 10 and with increasing volume and open interest leading a slight uptrend in the underlying.

Courtesy: https://web.sensibull.com/open-interest/fut-oi-vs-time?tradingsymbol=NIFTY

So, to conclude this is how we can use Open Interest with volume and price to predict market trend. Analysts complement open interest with some momentum indicators like RSI & Stochastics to get an understand of oversold or overbought position of the underlying but for now I will reserve this topic for a later discussion.