Derivatives

Decoding open interest in options trading

Venkatesh Bangaruswamy | Updated on July 24, 2021

Consider positive change in open interest before taking positions

If you are familiar with options, then you will know about option chain available on the NSE website. A useful information provided in the option chain is open interest. This week, we discuss open interest and its relevance in options trading.

Open interest vs. volume

Suppose there are totally 10 trades of 5 contracts per trade on 1500 strike call on an underlying on Monday. The total volume for this strike on Monday is 50 contracts. Think of volume as the number of contracts that change hands in each derivative contract during a day. Open interest (OI), on the other hand, refers to the total open positions in each derivative contract.

Suppose you buy 10 contracts of the 1500 strike call and sell four of these contracts by the close of the day. Assuming these are the only transactions on this strike, you have six contracts open; four of your contracts have been closed. So, the OI is six contracts whereas volume is 14 contracts.

Unlike volume, OI is cumulative. The OI in a derivative contract on the NSE starts on the last Friday of a month (the last Friday of the week for weekly contracts) when a new contract is introduced and continues till the contract expires. Take the July option contracts on the Nifty Index. The OI in these contracts started when the contracts were introduced on the last Friday in April. The build-up (increase) in OI will depend on the demand for each strike. Note that the OI for a strike will typically decline as contracts approach expiry.

How should you use OI in your trading strategy? You should look for positive change in OI. This indicates new open positions (long and short) added each day to the existing open positions in a strike. This is important for two reasons.

One, change in OI indicates liquidity in that strike.

For instance, the 15700 Nifty July call had the maximum increase in OI on Tuesday, indicating that traders were willing to build open position in this strike.

Continual increase in OI suggests liquidity because traders must close their open positions before expiry unless they want to take (or provide) delivery of the underlying in the case of in-the-money options. Liquidity is the reason we apply change in OI as an additional rule to the implied volatility rule while choosing an option strike.

Two, OI positions on calls and puts can be used to infer a trading range for the Nifty Index. For this, you should check the call and put strike that has a continual build-up in OI. Suppose the 15700 July call and 15600 July put has a continual build-up and shows the greatest increase in OI.

You can draw an inference that the Nifty Index could trade between 15600 and 15700 till expiry of the July contracts.

Optional reading

The above inference is based on the argument that institutional traders prefer to short options. Now, shorting options will be profitable only if these options expire worthless. That is, the underlying at option expiry should trade below the short call strike and above the short put strike. So, a continual OI build-up in the 15700 call could suggest that the index may trade below 15700 till contract expiry. Likewise, a continual OI build-up in the 15600 put could suggest that the index may trade above 15600.

A caveat is in order. Market conditions could change because of which traders should shift their positions to other strikes. For instance, if the fear of pandemic fades and the Nifty Index moves up, traders could build their positions in higher strike options, say, 16000 call and 15800 put. So, the inference is useful when you take cues from OI build-up closer to contract expiry. Note such inferences are best applied on the Nifty Index, not on equity options.

The author offers training programmes for individuals to manage their personal investments

Published on July 24, 2021

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