Updated: Apr 8, 2021
Welcome to the new article which is going to be dedicated to Future’s Open Interest. In our previous article, we had covered the topic which was on the market view. In this article, we are going to learn about the future’s open interest and how it is going to affect the market.
At the advanced level, we had discussed the market view, and there in the market view, I told you that there are lots of indicators. We are going to discuss one of those indicators in detail for you. So, let's start.
First, you have to understand how the practical or the professional option trader works? How they make a market view? When they are going to take a trade? So, here is indicator number one which tells you that whether the market is bullish or bearish. But first what is the future? Why I have discussed future contracts? But here we are going to learn only about the future. Why it is important? What are the different situations and what the situation tells us?
If there is an option, then there will be a future contract as well. So, options are with futures and the future is without any options. Now suppose some seller has sold one future contract and somebody has bought it. So, when a contract is sold, it is called one open interest and when that seller is going to buy back that contract, the contract is going to be closed and the open interest will be zero.
To understand that when you're somebody else wants a future contract, it becomes one open interest, and whenever that person who told earlier buy back again, it becomes zero. So, with that whatever the open interest you see in the market that much contract has been sold but not bought.
To understand open interest, we must first explore how options and futures contracts are generated. If an option contract lives, it must have had a buyer. For every buyer, there must be a seller since you cannot buy something that is not accessible for sale.
The relationship between the buyer and seller generates one contract, and a single contract equates to many shares of the underlying asset. The contract is observed "open" until the counterparty closes it. Adding up the open contracts, where there are a buyer and seller for each, affects the open interest.
If a buyer and seller come together and start a new position of one contract, then open interest will increase by one contract. A buyer and seller both exit a one contract position on a trade, then open interest decreases by one contract. However, if a buyer or seller takes place in their current position to a new buyer or seller, then open interest remains unchanged.
When you are focusing on the total open interest of an option, there is no way to understand whether the options were bought or sold. That's likely why many options traders ignore open interest altogether. However, you shouldn’t suppose that there's no important information there.
One way to use open interest is to look at it respective to the volume of contracts traded. When the volume surpasses the existing open interest on a given day, it indicates that trading in that option was exceptionally high that day.
Open interest also gives you key facts regarding the liquidity of an option. If there is no open interest in an option contract, there is no secondary market for that option contract. When options have high open interest, it indicates there are a large number of buyers and sellers out there. An active secondary market grows the odds of getting option orders charges at good prices. All other things being equal, the bigger the open interest, the easier it will be to trade that option at a reasonable price between the buyer and the seller.
I have told you that open interest is created by the option seller and closed by the buyer and generally it is considered that the future or options contract is created by big Institutions, HNIs, the people who are there with lots of money and lots of experience and knowledge. That's why if you understand there is a set of 10 million future open interest that means that 10 million contracts have been sold but it has not closed and the second important point is why it is important to learn about future open interest?
Understand this, big people or big institutional sometimes they create a kind of miracle or you can say kind of confusion in the stock market. How they created. Generally, they start selling in the cash market and start buying in the future market. So, what happened they try to manipulate the market in some way using future contracts and keep buying the future options. They keep selling in the cash market and the stock started to get down. It started to fall and at the same time, they start creating new options in the future market. So that way, they create artificial demand in the stock and they can move the prices up and down.
So, when you understand this the open interest is high but the stock’s price is getting increasing. This is an artificial demand or supply situation and this is not natural and then you can take the action accordingly. Sometimes you might have seen that some share this keep going up is in the fall. Sometimes it happened that the stock has got very good but the share price is falling. These are the operators who are trying to manipulate using the future and option contracts.
So, in conclusion, I would like to say that open interest plays a major role in options trading. Keep your knowledge up before investing in the stock market.