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Open Interest Trading Strategy

The Indian Futures and Options market is just about 15 years old. However, in the last few years, the F&O market (especially the Index options market) accounts for over 85% of the daily volumes on the NSE. With the F&O increasingly becoming a key and driving feature of Indian markets, it is essential to understand how key aspects of the F&O market gives us interesting clues about the emerging picture of the stock markets.

Understanding the concept of Open Interest (OI) data in F&O..
One of the key aspects that analysts and traders normally tend to look at is the Open Interest (OI) data. OI refers to all positions that are still open. Let us understand this with a practical example. Let us understand the steps to the creation and reduction of open interest with respect to futures.

Scenario 1: A buys 1 lot of Nifty Futures and B sell 1 lot of Nifty Futures, and then the market OI in Nifty is 1 lot. If both A & B decide to reverse their positions then the OI of the Nifty will come down to 0.
Scenario 2: A buys 1 lot of Nifty Futures and B sell 1 lot of futures, creating a market OI of 1 lot. The next day, A sells his 1 lot to C. The OI of the Nifty still remains at 1 lot as only 1 party is replaced.
Scenario 3: A buys 1 lot of Nifty Futures and B sell 1 lot. At the same C buys 1 lot of Nifty futures and D sells 1 lot. Similarly, E buys 8 lots of Nifty Futures and F sells 8 lots. In this case the total OI of the Nifty Futures will be 10 lots.

In short the OI of the Nifty contract will keep expanding as new participants keep initiating fresh positions in the Nifty. That is the crux of the concept of OI.

What does the OI basically indicate to a trader?
The OI shifts can give some interesting clues for the traders and even investors who are looking to take positions in equities. When there is interest building up in a stock, one of the first indications you get to see is that there is an increase in the OI of the stock as there is widening of the ownership and more fresh investors are taking positions in the stock. On the other hand, declining open interest, especially in case of stocks that have seen a good rally, could be an indication that the rally is about to come to an end.

OI data is also very useful in identifying turnaround points. Normally, as a trader or even as an investor you make profits when you are able to identify when a trend is turning around. There are a few clear signals in such cases. If a stock is bottoming out, you will see a mix of fresh OI building up happening with institutional build up of OI more prominent. Exchanges do report overall accumulation figures in case of MFs and FIIs and that gives us important clues about the turnaround. The reverse is true when you are trying to identify a turnaround at the top.
Comparing OI data and the stock price..
This is perhaps the best use of the OI data. When you compare the nature of OI movement with the medium term price trend, you get a clear idea of what is happening in the stock. Let us look at 4 such special situations..

If the Open Interest of the stock is rising and the price is also consistently rising, it is considered to be a healthy sign. It is a sign that investors are getting interested in the stock and there is also distribution of ownership that is happening. This is a key data point that helps traders and investors to judge the sustainability of a stock rally.

How do you interpret the situation if the OI of the stock is falling but the stock price is rising? This is a clear sign that the market is weakening. One can interpret it as a situation where the stock rally is being driven by short covering. Short covering is a case of shorts that are stuck in the position and are booking losses. This is a sign that fresh buying is not happening and the stock prices could start correcting once the short covering is over.

How do you interpret if the price is falling but the OI is rising? That is not a good sign. It basically means that fresh short positions are being built up and that is a sign that market expectations of the stock are sharply negative. It is a sign of weakness since shorting only happens when traders expect a deep correction in the markets.

How do you interpret when the OI is falling and the price is also falling? There could be two interpretations. Firstly, it could mean that long positions are unwinding and that could be a reason for worry in the markets. But it also means that the stock is becoming light in terms of F&O leverage and that is good news as the froth is likely to be out of the stock. Many cash market investors look at this as a positive signal.

OI is a key metrics for traders. When juxtaposed with price movements, it can give interesting market clues.

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