The Hindu Business Line : Open interest and trade volumes — Important indicators in determining trends

It is a common misperception that the open interest is the summation of the number of long positions and short positions. Since derivatives result in zero sum — a buyer exists only if a seller is present — it is sufficient if either the number of outstanding long positions or short position contracts is known.

Chiragra Chakrabarty
V. Venkat Giridhar

The term “open interest” of a particular commodity futures contract refers to either the number of outstanding long positions or outstanding short positions that remain to be settled and are not squared off.

Open interest can be determined at any point of time during the trading cycle (existence) of the commodity futures contract. Open interest is dynamic in nature and increases or decreases depending on the number of such outstanding positions.

Zero sum

The underlying philosophy of derivatives trading is that it results in a zero sum.

For every outstanding long position in a commodity futures contract, there needs to necessarily be a corresponding outstanding short position in the same commodity futures contract (of same expiry month).

In other words, there is a buyer of an underlying asset at some point of time in future if an only if there is a seller of the same underlying asset at that particular point of time in future.

It is a common misperception that the open interest is the summation of the number of long positions and short positions.

Since derivatives result in zero sum — a buyer exists only if a seller is present — it is sufficient if either the number of outstanding long positions or number of outstanding short position contracts is known (since both long and short positions in the same futures contract are necessarily equal).

Open interest is also different from volume of trades. Volume of contracts traded for a particular trading session refers to the total number of transactions that have occurred during this period.

It may be noted that during a particular trading session, the open interest may have increased or decreased (depending on outstanding positions prevailing at that point of time). But every time a transaction occurs, the volume of trades during the trading session only increases.

Bullish market

The combination of open interest and volume with technical indicators provides important information regarding the trend prevailing in the market. If the prices are increasing with a corresponding increase in both open interest and volumes, it is usually a strong indicator of bullishness in the market.

On the other hand, if both the open interest and volumes are waning with increase in prices, it is a signal of an impending reversal of the prevailing bullish uptrend.

Bearish market

If the prices are decreasing with an increase in open interest and volumes, this is usually an indication of sustained bearishness in the market.

Alternatively, decrease in prices with reduction in open interest and volume is usually an indication of an impending reversal of the prevailing bearish trend.

In a bullish market, increase in open interest indicates that new buyers are entering the market. In such a situation, usually the uptrend can be expected to continue. In a bearish market, an increase in open interest indicates that short sellers are dominant.

Sometimes, it may so happen that with decreasing prices, open interest also decreases, thus indicating that long position holders are unwinding (squaring off) their existing positions.

But when open interest is decreasing while prices are increasing, it is an indication that short covering is taking place in the market.

Short covering refers to the unwinding of short position holders by squaring off their existing short positions. In such a scenario, the uptrend is unlikely to be sustained, if there is a lack of new buyers in the market.

Static open interest usually indicates a possible market top or bottom and subsequent trend reversal.

The higher the volume traded, the more likely a trend will continue. Rising open interest confirms that new investment is supporting the prevailing trend.

It needs to be emphasised that open interest and volumes are not the sole determinants of the price trend, but provide sustenance to a clear understanding of the direction of the markets.

It is imperative that the open interest and volumes are analysed in conjunction with technical indicators and fundamental factors affecting the market prices.

(The authors are with the Multi Commodity Exchange of India Ltd. Their views are personal and do not reflect those of the MCX.)

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