Intraday trading is a self-explanatory term that is used to describe trading that occurs in a day. One of the concepts an intraday trader has to understand is open interest.
What is open interest?
Simply put, open interest (OI) is the sum total of the outstanding contract numbers held at the end of every trading day. These are positions that are yet to be closed; ie, open. Open interest is a measure of the overall activity level in the futures and options market. Every time two parties, ie, the buyer and the seller initiate a fresh position, the open interest increases by a single contract. If the traders or closing the position, then the open interest is lowered by a single contract. If the buyer or seller passes on their position to a fresh seller or buyer, then the open interest does not change.
If the OI has increased, it means that the market is seeing an infusion of money. If the OI is down, it means that the current price trend is nearing its end. In this sense, the OI is an indicator of changing trends in prices.
What is volume?
Traders should also understand that open interest is not the same as volume. Volume refers to the number of contracts traded in a day. Volume is a reflection of the number of contracts that have occurred between seller and buyer; irrespective of whether a new contract has been created or an existing contract has been transaction. The basic difference between OI and volume is that while open interest indicates the number of contracts that are open and live, volume indicates how many were executed.
Price action and its role
One more parameter that one needs to keep in mind while discussing OI is the price action. Price action in trading terms is how the price of a security moves on a graph, plotted over a period of time. It refers to the upward or downward price trend of a certain security.
Most traders use volume in association with OI and price to analyse the market. The general rule of thumb is that when the price is rising, and the volume and OI are up, then the market is strong. On the other hand, even though the price is rising, if the other two parameters are down, then it is a weak market. Here’s a chart that helps you understand the rules for open interest and volume:
If you are a trader, here are some tips to use OI to see market performance:
- – When the OI is on an upward trend and the price action is also seeing an upward trend, it means that the market is seeing an infusion of money. It means there are buyers and therefore, the market is considered bullish.
- – When the price movement is upward but the OI is dropping, money may be exiting the market. This is the sign of a bear market.
- – If price makes a sharp drop and OI is very high, it still means that the market scenario is bearish. This is because those who bought at the top now seem to be losing. There is the likelihood of panic selling in such a scenario.
- – If the prices are on a downward trend and the OI is also dipping, it means holders are under pressure to liquidate their positions. This is a sign of a bearish market. It may also be indicative that selling may peak soon.
In conclusion, OI is of significance because it tells you the number of contracts are live, or open in the market. When new contracts are added, OI increases. When a contract is squared off, the open interest decreases. Volume is another term that is often used in conjunction with open interest. Volume is indicative of how many trades were conducted on any given day. But it does not carry forward into the next day. OI, on the other hand, has implications on the next day, and is live data in that sense.
Open interest, price and volume information put together helps intraday traders to understand the position of the market. It gives an intraday trader an idea of whether the market is bullish or bearish.