Open Interest (OI)
Open Interest is another indicator of market psychology and is applied to the derivatives market.
Open interest is defined as the total number of outstanding futures or options contracts that have not been exercised, close, or expired. OI thus is the total number of open contracts of a security in the market. it represents the total number of all long and short contracts in the market on any given day. it reflects the difference of opinion among bulls and bears.
OI falls and rises only when a new contract is added or deleted. thus:
- Open interest rises when one long buyer and one corresponding short seller enter the market,
- OI falls when one long buyer and one corresponding short seller close their positions.
OI provides an indication as regards the liquidity of a particular contract or market. High levels of OI signal a fair amount of liquidity while a low level of OI signifies lack of liquidity in the market.
Open interest is of value to traders who deal in the futures and options market. they use open interest data with volume analysis. it reflects the psychology of the market and represents the ongoing conflict between bulls and bears:
- if both open interest and price are increasing, it is a sign that new buyers are pouring into the market with a strong bullish view. in such a saturation, you can expect the up trend to continue.
- when open interest is increasing while price decline, it indicates the dominance of short sellers in a technically weak market. this is a bearish sign.
- Declining open interest and slipping prices indicate liquidation of short positions by traders. typically, these will be replaced by fresh shorts who will not be as strong as the departed traders. declining OI along with falling prices also means the strong fresh longs are taking positions therefore suggesting bullishness. you can expect a rally to follow.
- when open interest is declining but price are rising, short covering is the most likely cause suggesting that the overall market is weak. the smart money is probably booking profits. this is a bearish sign.
- if open interest remains constant while the price keeps rising, one should be cautious as it may be a warning sign for an immediate top.
- when rising trend of open interest begins to reverse, one may expect a bear trend.
- if price are range bound and open interest is rising, this is a bearish sign as it indicates that institutions, and big players are taking short positions and the long retail traders will lose.
- if prices are range bound and open interest is falling, it is a bullish sign as this means that the smart money is covering its short positions.
OI for Bullish trend
A rising open interest points to and increase in the number of players who, in turn, will push the ongoing trend forward. Open interest that increase during and up trend reveals that some bears believe the market to be too high, but if the up trend continues, they are trapped and their subsequent short covering propels the market even higher. however, open interest that remains relatively constant during an up trend indicates that the supply of losers has stopped growing and only the previous buyers who are looking to make a profit from their position are entering. there fore, the up trend is likely to reach its fag end.
OI for Shorts trend
Short sellers become aggressive during a sown trend where bottom pickers remain the only buyers. Long term traders also exit their positions when prices fall too far, so prices get pushed down even lower. A downtrend is likely to continue when open interest rises in a declining market. if open interest remains flat in a down trend, it indicates lower participation by the bulls, and the presence of bears who shorted earlier but now want to cover and book profit. this profit taking causes a flat open interest in a down trend.