The Hindu Business Line : Profiting from open interest

Call it wishful thinking, but how would it have been if you had known a day before that a particular company’s shares would go up the following day? Obviously great. But, sadly such premonitions are unheard of, at least in the world of stocks. Nonetheless, there are some stock market indicators that can, if not point at the exact direction the stock might move in, indicate that there could be something brewing in it. Open interest is one such indicator. Studying trends in open interest can help you spot stocks that are witnessing a notable build up in trading interest and hence may see a sudden spurt in price.

But, to best appreciate the implications of open interest, sample this. On June 10, a day before Ranbaxy made the big announcement, it added over 3.7 crore shares in open interest! This means, so many new contracts had been created in Ranbaxy just a day before the promoters’ announced a stake sale. On retrospection, we know that this addition in open interest was quite significant.

What is open interest?

Open interest simply put is the total number of open contracts on a security, including the number of future contracts or options contracts that have not been exercised, expired or fulfilled by delivery. So, any significant increase or decrease in open interest can be safely assumed as an indicator of changing market sentiment on the underlying stock. But what exactly makes this indicator click? It is the fact that stock markets are not efficient all the time.

That is to say, that all material information of a company or its stock is not available to all the market participants all the time. This discrepancy was displayed in the example of Ranbaxy, in which case some of the market participants had somehow got a whiff of the upcoming news-break a day in advance.

How to read open interest?

Changes in open interest can be considered as a good indicator of the flow of money into the derivatives market. However, on a standalone basis, they do not give away sufficient clues on the direction of the likely move in the underlying. So, to circumvent this limitation, changes in open interest should be read along with the change in price of the underlying.

Increasing open interest and rising prices

If the open interest has risen in tandem with the underlying price in the markets, it can be safely construed as a bullish signal.

Note that addition of open interest signals the entry of new money into that particular stock or index. And since the price of the underlying has also risen, it can be assumed that the new money has been used to create fresh long positions.

Increasing open interest but falling prices

This is a bearish signal. The addition in open interest on the back of falling prices suggests that the new money which is entering that particular stock or index derivatives has been used to create fresh shorts.

Decreasing open interest but rising prices

Interpreting such diverse trends can be quite tricky. When despite a decrease in open interest, the underlying continues to move up, understand that there can be more to it than what might meet the eye.

To begin with, the fall in open interest signals that market participants are squaring off or closing their existing positions.

But since there is also a rise in price, understand that it is a precursor to reversal in price trends. That is, the up move in the stock price or the index may only be temporary. This means that prices may soon begin to fall since the hitherto rise in price may have been due to squaring up of short positions.

Decreasing open interest and falling prices

This again signals a trend reversal. Decrease in open interest at a time when even the prices are falling can be attributed to the forced closing of long positions by traders. This means, the fall in the stock of the index could have bottomed out and an uptrend may be in the offing.

Nonetheless, note that none of these interpretations are sacrosanct per say.

Making trading decisions solely based on such interpretations therefore may not always pay off.

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