Open interest (OI) refers to the number of futures or an option contract that have not been closed by traders since they initiated their position. OI for a contract is cumulative; it starts when the NSE introduces a new contract and increases (decreases) when positions are added (closed) on a trading day. Previously, we discussed how market participants interpret OI and prices. This week, we revisit this discussion, specifically looking at OI in a sideways market.

Price and OI

Suppose the underlying moves sideways and the OI increases. What can you infer from this observation? A compelling argument is that the build-up in OI represents accumulation. That is, traders are building long positions in anticipation of an upside breakout. While this interpretation may be logical, initiating a position based solely on this argument is risky. Why?

An increase in OI is possible only if a short position is initiated for every long position added. It is difficult to argue that an increase in OI when the price moves sideways will always result in an upside breakout. What if the shorts have more power than the longs? It is highly likely that the price can breakdown. Of course, you can read the price patterns from the chart to arrive at a directional view. The change in OI in relation to the underlying price can be informative, but the chart pattern can tell a better story. So, it is better to read the chart pattern first and use the change in OI as additional factor to confirm your view.

Likewise, the change in OI can be informative as a signal when a trend is weakening. Suppose an underlying price moves up, but the OI declines. This could be because the long positions are unwinding. Of course, it also means the shorts are closing their position. But the long unwinding can be taken as a sign that uptrend may be weakening, perhaps, a sign of bull exhaustion. You may immediately see a similarity in the argument with negative divergence between price and an indicator or an oscillator. Take the relative strength index (RSI). There is negative divergence when the RSI is making lower highs even as the underlying is making higher highs. This is an indication that the uptrend could be weakening. You can similarly interpret the decrease in OI when the underlying or futures price increases.

Note for traders
Volumes in options are important for intraday trading, not necessarily for position trading
Optional reading

It is important to have cluster of evidence to confirm a trend. Typically, the primary signal is the price pattern. The secondary signals can be an indicator, or an oscillator read with change in OI. Note that volumes in options are important for intraday trading, not necessarily for position trading. This is because you will trade European options, which can be only exercised at expiry. So, liquidity (captured by the change in OI) is important because you may want to close your position before expiry to reduce losses from time decay (theta).

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