Tuesday, February 13, 2007

Deciphering Futures Open Interest (OI).

Open Interests in futures contracts has always puzzled me, what it means when open interests are reducing with decreasing price? or reducing with increasing price? A rather common answer to this is that open interest should increase in the direction of price movement implying if the price increases the open interest should increase. Actually a lot is happening underneath, which is not so obviously clear. So I started with an example. Here is the deal -

Lets say at the end of yesterday OI was 100 and futures were trading at the same price as that of the underlying, say Nifty at 4100. Now at the end of today Nifty is trading at 4050 and futures are trading at 4045, but the open interest at the end of the day was 80. What this implies is ->

There are more "new sellers" joining in than the buyers (futures started trading at discount). Lets say 30 new sellers come to the market and 20 new buyers come to the market. So Assuming no one squared off their position, we should have an increase in open interest of 20 (each new buyer bought from a new seller), but we still have 10 sellers who have to find out 10 buyers. Where do they come from? Obviously original sellers have to square of their positions. So the net result is as follows No original buyers squared off their positions, 10 original sellers squared off their positions. This indicates a possible build up in "short" positions (sellers are more agressive and some week hands got out.) Chances are that selling will continue.

But lets say open interest actually reduces to 80. What this indicates is atleast 50 sellers got out of the market and 40 buyers got out of the market (assuming 20 new buyers joined the market). This is an indication of "shorts squared off", more than the longs, indicating this was just profit booking and no net new sell-offs.

Now lets assume that at the end of the day nifty was still down to 4050, but the futures were trading at 4055, (premium). This means there are more "new buyers" than "new sellers". Assuming that the open interest increased by 10 and lets say there are 30 new buyers and 20 new sellers. So what happened is 10 original sellers squared off their positions, but 20 buyers squared off their position. Possibly indicating that weak hands are getting out of the market, we need to keep watching for the next day.

But if open interest actually reduced by 10 say. This means 40 buyers squared off their positions and 30 sellers squared off their position. Implying buyers are less comfortable remaining in market, watch out.

These examples are just for understanding and inference that I have drawn from them is completely personal, no claims about being right.

Actually there is a lot more to this than end-of-day figures. Typically OIs during trading ours is a bit different than end of the day and intra day variations imply a lot more at what level buying is happening and what levels selling is happening.

(While I wrote this further selling in Nifty continued, so I am puzzled again!!)

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