Indicator 3- Change in Open Interest
Welcome to yet another topic related to option trading strategies. In our previous article, we had discussed the open interest phenomenon. Now, in this article, we are going to learn about the change in open interest. How the change in open interest will affect the options trading. We will see in this article.
Let’s recap about the open interest. Open interest is the total number of futures contracts carry by market participants at the end of the trading day. It is used as an indicator to find out the market sentiment and the strength behind price trends.
Dissimilar to the total issued shares of a company, which mostly remain constant, the number of outstanding futures contracts changes from day today. Open interest is finding out by adding all the contracts from opened trades and subtracting the contracts when option trade is closed.
Open interest and volume are connected, one key difference is that volume adds up all contracts that have been traded, while open interest is a total of contracts that carry on open in the market.
Traders can believe in open interest as the cash flowing to the market. As open interest increases, more money is flowing into the futures contract and as open interest decreases, money is flowing out of the futures contract.
So, we are learning about the Options Strategies. We have already completed our basic articles about options trading and now we are in the advanced options trading article. So, if any one of you is landing directly on this article, let me tell you something that this is the whole article and it will be better if you read our basic option trading strategies article first, then only this advanced options trading possibly make sense to you.
So, today we are going to talk about indicator number 3 and that is the change in open interest. So, basically in the previous two indicators, we have known about future open interest, second call and put open interest. Today, we're going to learn about the change in open interest. So, what happens when the highest call open interest and highest put open interest was shipped from their positions. What does it tell you about the market movement? It tells you what is going on in the mind of the option seller.
Now, before I start, let me give you some brief you might be wondering why I am talking too much about open interest. The indicators are two types. One indicator is called a direct indicator and the second is indirect or passive. So open interest is the direct indicator or active indicator because it can be directly read. If you follow them properly, these indicators that directly reflect what is going on the mind of option seller and let me remind you that these option sellers are not a retail investor. They are a huge institutional investor or HNIs who made some view after so much research in all.
If you follow this open interest, you can directly peek into their mind and understand what is going on. So, it is going to tell you whether the market is ready for some breakout, whether the market is going to shift from one range to another range or whether the market is just going to be sideways without any movement and it’s very important before you take any kind of options. This is important because when there is a movement that is a change in the thought process of the market participants with special sellers and the same thing is going to reflect.
Analysts typically use open interest to validate the strength of a trend. Increasing open interest is proof of the trend whereas decreasing open interest can be a signal that the trend is losing strength.
The idea is that traders are carrying the trend by entering the market that increases the open interest. As traders forgot faith in the trend, they exit the market, and open interest decreases.
Open interest is one inconstant indicator that many futures traders use in their analysis of the markets used in coincidence with other analyses to support trade decisions. The big changes in open interest can be an indicator when some participants are entering or leaving the market and may give a hint to market direction.
It is all about the thought process. Is there any change in the thought process? What happens it only moves up or what happens if only put moves down? As most the situation is going to give you a different market view and this market was coming directly from the mind of the people who make the option and future market. You can say that live news is in indirect indicators. Like you can get a piece of news just maybe the economy is going to do something, Reserve Bank is going to announce something. There can be some effect on the market but not directly. It may be indirectly.
Even if they are going to react, how much the market movement will be? This news, coming policies, and all others are a passive indicator. If you understand how to study the change in open interest, you can understand the change in market movement, the change in market thought process, the change in the direction, where the market can go, and many more. I hope you get the idea a little bit about the change in open interest.