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Open Interest analysis to identify Market Trends

"Unlocking the Power of Open Interest Analysis: A Comprehensive Guide to Identifying Market Trends

Mon Mar 6, 2023

"The beauty of Open Interest analysis is that it allows traders to see beyond the noise of market fluctuations and identify the underlying trends that truly drive price movements"

Introduction:

While trading people focus on either Fundamental side (Import, Export data, Seasonality, Commodity fundamentals and news) or on technical aspects (RSI, Choppiness Index, Moving Average, etc other indicators), But there is also another aspect called as Data Analysis (Open Interest and Volume Analysis) which we will look in this article. A common question many traders and investors often ask or are confused about is what is Open Interest? How can we analyze the correlation between price, open interest and volume? etc. But no need to worry now all your questions will be answered in this article.

Open Interest:

OPEN INTEREST means POSITIONS of TRADERS which are OUTSTANDING and not yet squared off. Open interest is the number of active contracts. There are only two types of positions that a trader can take in the market, LONG & SHORT

Example:

TimeActivityOpen Interest
Jan 1Ajay buys 1 option and Amit sells 1 option contract1
Jan 2Ravi buys 5 options and Ram sells 5 options contracts6
Jan 3Jay buys 5 options from Ravi who sells 5 option contracts.6

Pros:

  • To identify market trend
  • OI and Change in OI % helps to understand price movements
  • High OI reflects greater liquidity and Lower OI reflects less liquidity.

Cons:

  • It only helps in identification of direction or trend but does not indicate the time it would take to show results.

Vocabulary

Sr No

Term

Interpretation

1

LONGS

To be Bullish.

2

SHORTS

To be Bearish.

3

Long Unwinding

It indicates that the longs exiting their positions

4

Short Covering

It indicates that the investors are closing out their short positions

Market trends and different conditions.

1. If PRICE is rising and OI is rising, the market is STRONGLY BULLISH.
Description: If PRICE and OI both are rising, it means that every new contract that is being added is dominated by bulls, that’s why PRICE is rising with every new contract addition. LONGS will always be equal to SHORTS just that LONGS are dominating SHORTS in the transaction, that is why PRICE is rising. So, OI is rising, which means new contracts are being added and indicates market/share is STRONGLY BULLISH.

2. If PRICE is rising but OI is falling, the market is SLIGHTLY BULLISH.
Description: If PRICE is rising but OI is falling, it means that the rise in price is due to SHORT COVERING and not bullishness. See why is OI falling? It’s falling because positions are being squared off and the number of open contracts in the market is reducing. But since PRICE is rising with it, it means that SHORTS are SQUARING OFF and dominating LONGS in the transaction. Thus, it can not be called BULLISH. It is SLIGHTLY BULLISH. It can be a TRAP for new LONGS. 

3. If PRICE is falling, OI is rising, the market is STRONGLY BEARISH.
Description: If the price is falling and OI is rising, it means that SHORTS are dominating the LONGS. And since OI is rising, it means that new contracts are being added. But, since the price is falling, it means the new contracts which are being added are dominated by SHORTS, not LONGS. Hence, it is STRONGLY BEARISH.

4. If PRICE is falling and OI is falling, meaning the downfall in the market is limited.

Description: If PRICE is falling and OI is falling, it means that the fall in price is due LONG UNWINDING. See why is OI falling? It’s falling because positions are being squared off and the number of open contracts in the market is reducing. But since PRICE is falling with it, it means that LONGS are SQUARING OFF & dominating SHORTS in the transaction. Thus, it can not be called BEARISH. It is SLIGHTLY BEARISH. It can be a TRAP for new SHORTS and can be a sign of trend reversal.

Why should a trader care?

Once a trader analyzes the Price movement, OI and Volume they can read the market sentiments better and make their positions or trade accordingly. The following table would help you to understand it better.

Key takeaways

  • Price increasing during an uptrend and open interest on the rise are interpreted as new money coming into the market. That reflects new buying, which is considered bullish.
  • If the price is rising and the open interest is on the decline, short sellers covering their positions are causing the rally. Money is, therefore, leaving the marketplace. This is taken as a bearish sign.
  • If prices are in a downtrend and open interest is on the rise, it suggests new money is coming into the market. This shows aggressive new short selling. They believe this scenario will lead to a continuation of a downtrend and a bearish condition.
  • Suppose the total open interest is falling off and prices are declining. This scenario suggests weakening of downtrend and start of strong position as most of the sellers have sold their positions.


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