Now open interest is the number of, open contracts in the market. Open interest is different from volume and it is used as an indication of strength of market. You might be finding information from options trading chart. Now if you look at open interest and volume, open interest is actually not as same as volume. With volume both entry and exit, cause the volume to increase but with open interest, only entries cause open interest to increase, while exits cause open interest to decrease. Now open interest is interpreted, differently for futures and for options. In futures if you see price rising or falling, along with open interest addition, is seen as a sign of strength.
Important Strategies for Beginners
Whereas when you take a case of options, open interest rising at strike price is seen as resistance, in case it is rising at calls and it is seen as support, if open interest is rising at puts. Hope this particular point is clear because we will be covering more on these specific points, when we discuss open interest in detail. Now, open interest, as I said, is computed by adding all contracts that lead to opening of a trade. Whereas whenever closing of a trade happens, then you need to subtract those contracts with open interest. So trader one opens a long trade by buying one contract, therefore, open interest increases to one. Trader two opens a long trade by buying five contracts, therefore the net open interest now increases to six.
Trader three opens a long trade by buying two contracts, therefore, open interest increases from six to eight. Now trader four opens, a short trade by selling, three contracts so open interest increases to 11. So if you note in all these transactions, all these traders are actually opening up a position which is why open interest is increasing. Whereas if you look at trader one here, he then closes his long trade that he initiated here by selling one option contract and hence the open interest decreases to 10. So I hope this particular point is clear because many traders get confused as to what open interest is. So open interest is nothing but, whenever you initiate a new trade or whenever you open up a trade, then open interest addition happens. Whereas whenever a trade is being closed, then open interest decreases.
Clearing You Basic Doubts First
I hope this particular basic point is clear. So let us now look into how to interpret open interest. Now open interest is often used as a confirming or nonconforming signal of the current, price move that you’re seeing in the market but on its own that is on a standalone basis, it does not provide any indication of the direction of price movement. Now, this is a very important point. Now open just states that how many contracts, are currently in open position but it doesn’t tell you who is long or short. Now, increasing open interest shows that, there is strength behind the current move and the price might trend because the number of contracts, essentially is increasing whereas decreasing open interest shows that, there could be a weakening of current price trend, as traders are closing out their positions, more rapidly than new traders are opening them.
So what you have to do is you have to take open interest as a confirmation signal along with price movement. If you look at futures, look for price movement and then confirmation of open interest, towards that movement. Now, open interest is also used to determine, if a market is more likely to trend or it is going to remain in a range. Now increasing open interest, shows that the rate of new positions, is increasing in the market which actually indicates that the market is being, actively traded and it is more likely to trend. Whereas whenever open interest decreases that actually shows that the rate of new position, is actually decreasing which indicates that market, maybe entering into a phase of consolidation or less activity and therefore, it is more likely to remain range bound.