Role of Open Interest in Futures Markets – Purpose, Impact & more

Open interest is a vital concept which often gets asked along with the concept of futures trading. Most traders and investors often associate the concept of volumes with open interest.

So in doing this, they like to understand how they are to benefit in a trade and what each of them means individually.

The concept of open interest allows a trader to make better decisions while they are trading.


What is Open Interest in Futures?

Open interest is a practical concept in the futures market. It refers to the number of futures and options which currently stand open in the market.

Open Interest in Futures MarketAs you may have already understood from the operations of futures and options, every transaction in the market has two sides. If there is a buyer, there will always be a seller to a trade.

Let us take an example to understand this concept. Let us assume that the seller is selling one contract to a buyer.

On this contract, the seller will be said to have a short on this contract while the buyer will have a long on the contract. Thus the open interest, in this case, will be 1.

Further, let us assume that there are 5 traders in the market. They are willing to trade in futures of Nifty. Let us name them as A, B, C, D and E.

A look at their day trading activities will easily reveal to us everything about the variations in open interest.

Let us go through the days of the week to know about their trading positions.


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Monday

A purchases 6 futures contract and B purchases 4 futures contracts. It is C who sells these 10 contracts to A and B. So, in all, there are 10 contracts in this trade.

There are 10 contracts on the long side and 10 on the short side. This brings the open interest to 10.

Tuesday

C decides to eliminate 8 out of 10 contacts that they had sold yesterday. This is when D enters the market and buys 8 contracts from C. In these transactions, it is vital to note that no new contracts are created in the market.

What happened here is a simple transfer of contracts from one trader to another. Thus, the open interest will continue to stand at 10 only.

Wednesday

D decides that they want to add 7 more short positions in addition to the one they had taken yesterday. A and B also want to increase their long positions. D sells 3 contracts to A and 2 contracts to B.

Now, it is clear that 5 new contracts have formed in the market. C decides that they want to close all open positions so they go long on 2 contracts, which they transfer to D. Thus, C and D no longer hold any contracts.

By the closing of this day, there will be a total of 15 long and short positions in the market. Thus, we can say that the open interest is 15 in the market.

Thursday

E makes an entry to the market and decides to sell 25 contracts. Now, D decides that they want to liquidate and close position on 10 contracts and thus, they buy 10 contracts from E.

A also adds 10 contracts from E and B decides to purchase the remaining 5 contracts from E. It is clear that 15 new contracts are now added in the market.

Thus, the open interest will now stand at 30.

Friday

E decided that they want to square off 20 out of 25 of their contracts which they had previously sold. They go ahead to buy 10 each from A and B.

Since 20 contracts from the market are now squared off, only 20 contracts remain in the market. Thus, the new open interest will be 10.

What is the purpose of Open Interest?

As can be seen from the data above, the purpose of open interest is to indicate how many open positions in the market exist.

Open interest gives a fair idea about the liquidity position in the market.

A bigger open interest indicates more liquidity in the market. This makes it possible for an investor to enter or exit the market at competitive bid rates.


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Interpreting Open Interest and Volumes

As is already clear, open interest tells an investor how many contracts are live and active in the market.

On the other hand, the volume is an indication of how many trades are executed on any given trading day.

So let us say that on a given day, 400 contracts are bought and 400 contracts are sold in the market. Then this would mean that the volume for that trading day is 400 and not 800.

On each trading day, a volume ticker starts with the count of zero and increases as and when trades occur. Thus, it means that the data of volume always operates on an intraday basis.

In complete contrast to volumes is open interest. It tends to increase or decrease as and when traders enter or exit from the market.

Thus, we can say that it is not dependent on the trading level in terms of intraday.

Changes in open interest and volume take place on a daily basis but the changes in volume levels today will have no impact on the volume levels tomorrow. The same is not true for open interest.

Even though their purpose individually may appear quite useless, some traders tend to make estimates about the market movement with the use of these numbers.

Impact of Open Interest & Market Volumes on Traders

Here are a few points which summarize how changes in the market volumes and open interest tend to impact the way in which traders perceive the market.

  • If the price increases and volume also increases, a trader will expect the market to be bullish.
  • If the price decreases and volume also decreases, an end to the bearish trend can be expected. This is the time when a reversal in the market can take place.
  • If the price decreases but volume increases, a bearish trend is one of the cards.
  • An increase in price and decrease in the volume could indicate an end to a bullish trend. This is when a reversal in market conditions can happen.

Open interest is not indicative of any directional movements in the market. The only thing that a trader can make out from them is the strength between bullish and bearish positions.

Impact of Open Interest & Prices on Traders

Here are a few key points which indicate how the changes in open interest and prices impact the perspective of a trader.

  • If the price and open interest increase simultaneously, more trades may happen on the long side.
  • If both price and open interest decrease at the same time, it would mean that traders with a long position are trying to cover up their positions. This phenomenon is popular as long unwinding.
  • A decrease in price but an increase in open interest would mean that there are more trades happening on the short side.
  • An increase in price but a decrease in open interest would imply that those with a short position are covering up their trade. This is popular as short covering.

A rapid change in the open interest merits caution since even a small change in the market could create a panic stricken situation.

So, it is always a good idea not to rest your decision solely on the state of open interest.


To conclude Open Interest in Futures

So in this article, we understood what open interest is all about. It is a measure of the number of contracts which currently stand open in the market.

When a new contract adds, the number of open interest will increase and vice versa. Any change in contracts between two parties will not impact.


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