Traders always look for indicators or metrics to help them understand underlying price trends. One such indicator is a set of metrics that relate to open interest (OI) and prices. You will find this information in online trading-related websites and on the NSE website as “Spurts in Open Interest”. This week, we show how this information is typically interpreted and discuss a contrarian view.
Bullish or bearish
Open interest refers to the total derivatives contracts that are outstanding on an underlying. For instance, if the OI is 1.72 lakh contracts on 17500 near-week call, it means that 1.72 lakh long and short positions are open on the strike.
You will find four sets of information relating to OI and price. The first one is rise in OI along with rise in price. This is typically referred to as long build-up and is interpreted as bullish. Why? If traders are willing to carry more open positions even as prices are rising, it could indicate that they expect the underlying price to trend upwards.
The second one is rise in OI along with slide in price. This is typically referred to as short build-up and is interpreted as bearish. This is exactly the opposite of the first one. If traders are willing to carry more short positions as prices are falling, it could indicate that they expect the underlying price to trend downwards.
The third one is slide in OI along with slide in price. This is typically referred to as long unwinding. That is, traders are either taking profits or cutting their losses and closing their existing positions.
And finally, the fourth one is slide in OI along with rise in price. This is typically referred to as short covering. The argument is that traders cover their short positions to cut losses when the underlying is moving against them.
Before you apply these indicators to take a directional view on an underlying, consider this. The objective of taking a short position is to keep the premium by capturing time decay. So, the maximum profit on short positions occurs at expiry when time value is zero — when the option expires worthless.
Now, consider the first metric — the rise in OI along with rise in price. Suppose OI increases by 20,000 contracts on Tuesday. It means that 20,000 long and short positions have been added at the end of Tuesday to Monday’s OI. Now, individuals typically buy options, whereas institutional investors typically short options against long positions in futures and underlying. If you accept that institutional investors are more discerning than individual investors, you may have to pause on the idea that directional view is always bullish. It would well be that institutional investors are building up short positions in options because they believe that the underlying is unlikely to close above that strike.
A similar argument can be used for the second metric — short build-up. If OI is rising even as prices are falling, discerning traders taking long positions could be betting on a reversal. How are you to know whether the long or the short will be proved right?
Change in OI is an important indicator for liquidity when you are trading European options. This is because European options can only be exercised at expiry. So, the ability to sell long position is important to take profits. An increase in OI indicates that both long and short positions have increased. That means traders must come back to the market to close their short positions. So, closing your long position should not be difficult.
Relating increase in OI and price to directional view of an underlying may not always work on its own as a metric. If you can discern the directional view on the underlying through charts, change in OI can be used as a good liquidity indicator.
(The author offers training programmes for individuals to manage their personal investments)