Open Interest | How to interpret it to find potential option trades

Open Interest | Identify market trends with OI

In this post, I will discuss simple strategies of analyzing and interpreting open interest data in confirming trend continuation or trend reversals.

I’m not an expert or guru on this topic. But as an Options trader, I will try to keep things as simple as possible and talk about extracting the information required to initiate a trade based on my trading experience.


By the end of this article, I hope that you would have a good understanding on how open Interest can help you in identifying market trends.

If you do not want to go through the whole article, then please open the table of contents below and select the specific topic that you want to read.

What is Open Interest?


Open Interest is a number that tells you how many options contracts are currently open in the market.

Open interest is used by traders for trend confirmation and reversals. It represents the total number of open contracts on a particular script.

How is Open Interest calculated?


OI increase or decrease based on the number of new traders entering and old traders exiting the market.

It is the total number of contracts bought or shorted by buyers and sellers on any given day. The open interest number gives you the total number of longs and shorts.

How does Open Interest increase or decrease?


When traders create new contracts which did not previously exist, option open interest will increase.

This means that a new buyer must take a long position and a new seller must take a short position. They create a new contract together in the market.

Additionally, OI can decrease if both the buyer and the seller close their existing position.

Lastly, the single contract that they had between each other would terminate and reduce the market’s open interest.

Let me illustrate with an example:


Arun, Shyam, Rahul and Chandan and Sandeep are 5 participants in the market.

  1. DAY 1 – Arun buys 50 contracts from Shyam

    Open Interest equals 50

  2. DAY 2 – Rahul buys 40 contracts from Chandan

    Open Interest increases to 90

  3. DAY 3 – Arun sells 50 contracts to Chandan

    Open Interest remains at 90

  4. Day 4 – Sandeep buys 40 contracts from Rahul

    Open Interest remains at 90

  5. DAY 5 – Rahul sells 40 contracts to Sandeep

    Open Interest increases to 130

  6. DAY 6 – Sandeep sells 30 contracts to Rahul

    Open Interest decreases to 100


From the above example, we can understand that:

  • OI can increase or decrease depending on the buy and sell of contracts.
  • OI goes up when a new trader trades with a new entrant.
  • When an existing position holder squares off with the entry of a new participant, OI remains the same.
  • If two existing position holders square off their positions, OI will decrease.

Why is Open Interest important?


High volumes along with high OI indicate greater hedge and trader participation in the options market.

Simultaneously, high volumes and low OI means that there is more speculative interest.

Similarly, using OI data, a trader can gauge whether short-term trend is bullish or bearish.

Open Interest and options


Many option traders make the mistake of ignoring OI, assuming that it is not really that relevant.

On the other hand, a number of traders give too much emphasis in its importance, assuming it to be a sole indicator of the liquidity of the contract.

The truth is actually somewhere in the middle and is certainly relevant. In other words, it should be used in combination with various other indicators and data.

Advantage of using Open Interest as a trading support tool


If we follow the changes in the OI figures at the end of every trading session, we can come up with some awesome conclusions in regards to the prevailing trend.

For example, increasing OI would mean that new money is flowing into the market. The result will be that the present trend would likely to continue.

Declining OI means that the market is liquidating and implies that the prevailing price trend is coming to an end.

Knowledge of OI can give an edge to identify early signals the end of major market moves.

Falling of open interest following a sustained price advance is often an early warning of the end to an up trending or bull market.

I will talk more about the various scenarios in the open interest strategies in the later part of this post.

Where do I find open interest?


There are multiple sources where we can find out the OI. The most reliable source is nseindia.com. Here you will find out the last trading day open interest.

nse option chain

NSE shows the total OI of each strike price as well as the changes in OI. You can also check the Open interest of individual scripts by typing the script name on the top field box.

To understand more on option chain, please read my article on How to read Nifty option chain

Personally, I use Zerodha Sensibull for tracking the Option Interest Data as it gives a much simple view of the increase and decrease in Option Interest.

Also, we can use their OI Charts to get a quick understanding of the major support and resistance levels without getting into any sort of Calculations.

Here are some screenshots I have taken from my Zerodha Sensibull account:

Open Interest | Zerodha Sensible daily OI chart

This is a daily Chart depicting the change in OI. It gives an easy visual presentation of where the major volumes of Calls and Puts are lying.


Zerodha Sensible intraday OI chart

This is an intraday OI chart and changes in real time. To know more about Zerodha Sensibull click here.


Now let us move forward to the next important discussion on open interest.

Interpreting the components of Open Interest


Price


When it comes to price action, there are a few things that need to be taken into consideration when analyzing open interest:

Momentum


Momentum describes how strong price moves into one direction. Check whether there is increasing large candles going in one direction or a lot of back and forth movements.

Volatility


Check the type of Candle formations. Monitor whether it is a continuation of full body candles or with a lot of shadows.

Support and Resistance levels


Monitor the open interest changes at the strong support and resistance levels closely. This will give an early indication as to whether the original trend is likely to continue or a reversal is in the making.

This is a very simplified way of looking at price information, but my purpose is to break down the underlying components that drive the markets.

If you learn to understand and interpret volume, OI and price action it can provide insights about the sentiment of investors as well as traders, thus enabling you to make much better trading decisions.

Volume


Volume shows the amount of trading activity in a given market on any given day.

Increase in volume means that there was more trading activity and more contracts were traded than on the previous day.

During trends, high and rising volume means that trading activity supports the continuation of the current trend because more investors or more contracts traded is providing support to the  current price movements.

Technical analysis also uses volume information to identify potential reversals.

If during an uptrend volume declines, and momentum falls, it signals that fewer people are buying into the trend and weakness is creeping in.

Where do volumes fit in with Open Interest?


Volume for an options contract is simply the number of contracts that have been traded on a particular day. Volume does not distinguish between how many contracts were opened or closed (long or short).

Volume and open interest are two key measurements that describe the liquidity and activity of contracts in the options and futures markets.

Volume does not give a clear picture about how many contracts are opened and still open in the market, while OI is a cumulative total of all the open contracts at the end of the day.

While volume will reset each day, the open interest carries over to the next day.

If you are an options trader, remember that just as open interest is a very important indicator, volumes also plays an equally important role for trade decisions.


Deriving information from Open Interest

Increase in OI, Volume rising and Increase in Price


Buyers are chasing the stock making the price rise. The open Interest is building up and the volumes too are increasing. This can be understood as a Bullish Trend

Increase in OI, Volume rising and Price Falling


Sellers are hammering the stock, making the price fall. The OI is building up and the volumes too are increasing as both are indicating an increase in shorts. This can be understood as a Bearish trend in formation.

Decrease in OI, Volume falling and Price Falling


It implies that bulls are squaring up positions leading to a fall in prices. However, volumes too are dropping and therefore the downside can be limited.

After the selling ceases, it can move in either direction with a higher probability of trending up.

Decrease in OI, Volume falling and Price rising


It implies that bears are covering shorts leading to a rise in prices. However, volumes too are dropping and therefore the upside can be limited.

Once the short covering is over, it can move in either direction with a higher probability of trending down.

What if there is no Open Interest in a script?


The reason that there is no OI showing up sometimes is that open interest is calculated after the close of every trading day.

It is recalculated for the next day. Whenever you see open interest on the platform, it will be for the last trading day.

In a case where the contracts just started trading today, there will be no open interest because there’s nothing before today trading.

Open Interest strategies to find Potential Trades


For long Calls, look for a decent rise in OI in the range of 8%-10%. It should be followed by an increase in volume and a decent rise in price.

Do not go for Calls of stocks that have already risen heavily. Instead look for stocks with a maximum of 2%-4% increase in price.

For Long Puts, look for scripts with a decent rise of 8%-10% in open Interest volumes and a decent fall in price.

Do not buy Puts of Stocks that have fallen a lot already. Look out for stocks that has fallen a maximum of 2%-4%.

Remember that you will get no more than 2-4 bullish or bearish stocks every day. These stocks are good candidates for swing trades.

Confirming successful breakouts:


During periods of consolidation, volume and open interest is normally low, declining and below average.

The challenge about breakout trading is validating a real breakout and being able to tell whether a breakout would be successful or result in failure.

Volumes and OI alone would not be able to explain all breakouts but they offer enough signals to help improve the accuracy of your analysis.

For example, if the price suddenly starts to move in one direction after consolidating for a period of below average volume and open Interest, while volume and Open Interest picks up, it is often followed by the start of a new trend.

When more traders enter positions, it validates the new trend and shows consensus with regards to price movements.

High Reversal probabilities:


Open Interest and volume analysis can often be a leading indicator when it comes to identifying market turns and reversals.

After a strong trend phase, if the price suddenly slows down and volume and Open Interests starts to decline, it signals that trading activity is likely to decline on the long side.

At particular Key support and resistance levels, a change in open Interest and volume can be probable indicator that market sentiment is undergoing a change.

Use Open Interest along with other indicators for buy/Sell confirmation


Even if open interest is suggesting a buy or sell, you must combine it with other technical indicators of your preference for confirmation.

Personally, I use Moving averages, Pivot points and type of Candlestick formation to confirm entry and exit signals.

Also, for long Call candidates, I look whether the strong has shown strong momentum over the last 14-30 trading sessions.

For long Put Candidates, I look at whether it is in a strong downtrend for the last 14-30 trading sessions.

If the selected script is near 52 week lows, the better is the probability of its continuation on the downside.

When should you avoid following Open Interest?


You should avoid it during Quarterly result seasons. If a company is expected to perform poorly prior to results the stock will fall and open interest rises.

If one looks at the options chain, we will likely see huge writing of call options and a relatively lower writing of put options.

Higher call OI than put OI will probably make the person inclined to buy a call, thinking that the stock will rise after results are out.

But the seller may have sold or written more calls knowing that downside probability are greater and that any possible upside may be capped.

Also, Sometimes the buyer might see many calls being written and interpret it as downside pressure and buy a put.

But post poor results, if company gives positive guidance for quarters ahead, the stock could surge despite posting poor results and cause a loss to the put buyer as call writers start covering their shorts.

This leads to OI of calls to fall as price rises.

Open Interest and Put Call ratio


The topic on Open Interest cannot be complete without mentioning the importance of Put Call ratio and how this can also act as an additional indicator to gauge the market trend.

ALSO READ: 6 options Trading Strategies that will make you broke before you know it!

What is a Put Call ratio?


Put call ratio is an indicator commonly used to determine the momentum of the options market.

It is a contrarian indicator meaning that the ratio looks at options buildup, helping traders understand whether a recent fall or rise in the market is excessive and if the time has come to take a contrarian call.

The ratio is calculated either on the basis of options trading volumes or on the basis of options contracts on a given day or period.

What does put Call ratio indicate?


A rising Put Call ratio greater than 0.7 or exceeding 1 means that traders are buying more puts than calls. It indicates a bearish sentiment is building in the market.

An increase in traded put options signals that investors are either speculating that the market will move lower or are hedging their portfolios in case of a selloff.

A falling Put Call ratio below 0.7 and approaching 0.5 is considered bullish since it means more calls are being bought versus puts. In other words, the market has a bullish sentiment.

How do I analyze Put Call ratio to make trade decisions?


In the case of PCR, I keep it simple and tend to go with what the writers are taking a call in terms of the market movement. The table below illustrates well as to how I analyze the put Call ratio.

Put Call ratio alone will be unreliable to identify change in trends. The ideal way to go ahead is to use it with other technical indicators and patterns.

That will give more accurate results rather than relying on this ratio on a standalone basis.

Where can I learn more about Open Interest | Put Call ratio?


There are many free resources available on the internet. One that I would recommend in terms of learning more about OI and put-call ratio is Zerodha Varsity


Zerodha varsity

Zerodha Varsity has a lot of quality content on open interest as well as other options trading topics.  The best part is that it is all available for free.

Click here to learn more about Open Interest and Put Call ratio on Zerodha Varsity

Alternatively you can also read good books which have good information of open interest. Some of the books that I would recommend as a must read for options traders are:

Option as a Strategic Investment

Volume and Open Interest: Classic Trading Strategies for 24-hour Markets 

The Bible of Options Strategies: The Definitive Guide for Practical Trading Strategies

Using Open Interest screeners to find potential trades


Using the OI strategies that we have discussed, you can use various open interest screeners available to quickly find potential trades.

One of the widely used tools is the moneycontrol.com Open Interest screener.

It has a lot of decent features and you can screen OI based on:


  • Highest open interest
  • Lowest open interest
  • Increase in OI and Increase in price
  • Increase in OI and decrease in price
  • Decrease in OI and decrease in price
  • Decrease in OI – Increase in price

Screener is available for all futures and options contracts and for all expiries. Click here to check out moneycontrol screener

Alternately, I use Zerodha Sensibull option Screener. It provides much more information than the free screeners available online.


Open Interest | Zerodha sensibull OI screener

Also, I can filter my Screen based on liquidity, volume spikes, upcoming events and max pain.

The OI screener can be categorized based on Short buildup, Long buildup, Short cover and Long unwind. You can also specify or filtered the IV range, IVP range, PCR range, Future and OI percentage change.

By filtering the noise out of so much data, the few results that come out through this screener provides me with the highest potential option trades.

Click here to know more about Sensibull option screener based on Open interest and PCR

Conclusion


Open Interest can be used as an additional support tool to your overall technical strategy.

This is not a Holy Grail tool and requires experience to judge the impact of open interest build-up at various stages of any expiry.

So to have a high probability in selecting the right trends, be it individual scripts or index, I would suggest that you understand open interest thoroughly and combine it with other indicators for a high success probability.


Reference


  1. https://en.wikipedia.org/wiki/Open_interest
  2. https://optimusfutures.com/tradeblog/archives/price-volume-and-open-interest-the-3-components-of-good-market-analysis/
  3. https://economictimes.indiatimes.com/markets/commodities/news/how-open-interest-can-show-stock-trends/articleshow/56996197.cms
  4. https://bullbull.in/market-iq/how-to-analyze-open-interest-data-and-generate-profitable-swing-trades/
  5. https://www.investarindia.com/blog/how-to-use-open-interest-in-future-option-trading/
  6. https://www.investopedia.com/ask/answers/06/putcallratio.asp
  7. https://www.adigitalblogger.com/derivatives/put-call-ratio/