What is Open Interest?

Open Interest and Its Calculation

Before we finish this module, we have to discuss one more important issue. The question frequently asked in the market is what is open interest and how is it different from volume? Many people also do not understand how volume and open interest data can be used? In this chapter we will try to answer these questions. After this chapter, you will be able to see and understand open interest data with volume data and how to use it in trading. You read this to refresh your understanding on the volume.

Open interest is the number that tells us how many futures or options contracts are outstanding at the moment in the market or have not yet been closed. You must remember that in every deal (or trade) there are two parties, a buyer and a seller. Suppose the seller sells a contract to the buyer, the seller is short on that contract and the buyer is long on the same contract. Because of this trade an open interest was created in the market.

Let us understand this with an example, suppose there are five traders in the market who are trading in Nifty futures, whose names are Arjun, Neha, Varun, John and Vikram. Let’s take a look at his few days of trading and understand how open interest changes. You have to understand this a little carefully.

Monday: Arjun buys 6 contracts, Varun buys 4 contracts while Neha sells 10 contracts to all of them. After these deals there are now 10 contracts in the market and 10 long (6+4) and 10 short contracts. Thus the total open interest in the market is 10%. You can see this in the table below:

Tuesday: Neha wants to exit 8 of her 10 contracts and makes a similar trade with John, who has just entered the market. So John takes the short contract from Neha. For now, it has to be noted that no new contract has been made here. An old contract itself has passed from one person to another. So the open interest will still be 10. You can see Tuesday’s deals in the table below:

Wednesday: John wants to make 7 more short contracts in addition to his 8 shot contract. On the other hand, Arjun and Varun want to increase their long positions. In such a situation, John sold three contracts to Arjun and two contracts to Varun. So now these 5 new contracts are formed here. On the other hand, Neha wants to close her 2 open positions. He sold both these contracts to John and now Neha has no contract left. Now the table will look like this:

As of the end of Wednesday, there are now 15 long contracts in the market and 15 short. So in this way the open interest is 15.

Thursday: A new player arrives in the market – Vikram. He sells 25 contracts. John wants to close his 10 contracts so he buys 10 contracts from Vikram, that means he transfers his 10 contracts to Vikram. Arjun also takes 10 contracts from Vikram and Varun decides that he will buy 5 more contracts from Vikram. In this way 15 new contracts are formed in the market. Now the open interest is 30.

On Friday Vikram wants to square off 20 of his 25 contracts. So he buys 10 contracts each from Arjun and Varun. In this way 20 contracts are squared off in the market. That is, 20 contracts are reduced in the market. So the new open interest is 30 – 20 = 10. You can see this in the table below:

This cycle continues in this manner. Now you must have got a little idea what is open interest. Open interest refers to the number of open positions in the market. One thing to note here is that if you look at the contract column in the above table and add all the positions assuming long positions as + and short positions as – you will get zero. Because of this also derivatives are called zero-sum games.

Have a look at the picture below-
Nifty Futures Open Interest as on 4th March 2015 is around 2.78 crores. This means that there are long positions of 2.78 crores and short positions of 2.78 crores in Nifty. In addition 55,255 new contracts were added on that day. This statistic shows how much liquidity is there in the market. The higher the open interest, the more liquid the market is considered to be and the easier it is to enter and exit the market. Also, the bid and ask rates are also good.

Estimation of Open Interest and Volume Data

Open interest data tells us how many contracts are open in the market i.e. not squared off while volume tells us how many trades have taken place in the market. On a sell and buy transaction, the volume increases by only one. For example if on a given day 400 contracts were sold and 400 were bought then the volume would be 400 not 800. Visually, both volume and open interest data may look similar, but both give different information. The volume data starts from 0 every day and increases as the trades happen so the volume data only increases on an intraday basis. But open interest is not the same as volume. Every day, as traders increase or decrease contracts, the open interest increases or decreases. Let us see the open interest and volume data created based on your previous example in the table below.

Note that open interest and volume are changing every day. But today’s volume has no bearing on yesterday’s volume, whereas it is not the case with open interest. By the way, both open interest and volume do not give much information in themselves, but traders look at these figures with price movements and make their own assessment of the market accordingly.

The table below will show you how traders use these data.

Cost	Volume	Trader’s assessment
Increase	Increase	Bulish
Decrease	Decrease	Bearish end of recession, beginning of change in trend
Decrease	Increase	bearish / bearish
Increase	Decrease	Bullish trend likely to end, trend reversal likely

Volume tells which direction the market is headed for that day but open interest does not tell the direction of the market. Open interest shows how strong the bull and bear positions are in the market. In the table below you can see how the trader assesses the market based on open interest data and price.

Cost	OI	Trader’s assessment
Increase	Increase	long deals
Decrease	Decrease	People are reducing long positions, also known as long unwinding.
Decrease	Increase	More deals short ones
Increase	Decrease	The short ones cover their positions, also called short covering

Note that if there is a significant increase in open interest and there is a significant rise or fall in prices, then it is time to be cautious. It simply means that there is a lot of excitement in the market and people are creating too much-leveraged positions. In such a situation, even a small wrong signal can create fear in the market.

With this, we now end this module of futures trading here.

Next, we will talk about option theory.

Highlights of this chapter

• Open interest refers to how many contracts are still open in the market.
• When new contracts are added, open interest increases and when contracts are closed, open interest decreases.
• When the contract is passed from one person to another, there is no change in the open interest.
• The volume data is for one day while the open interest is added every day.
• The information of open interest or volume in itself is not very useful, but if you look at it by adding it to the
• price, then you can understand how changes in these affect the market.
• High open interest means there is leverage in the market. In such a situation you should be careful.