Open Interest - Definition, Examples and Importance

Intraday trading, buying and selling financial instruments within the same trading day, requires a keen understanding of market dynamics and various indicators. One such indicator that can provide valuable insights to intraday traders is open interest. Open interest is a crucial metric used in analysing the potential direction of the market and making informed trading decisions. In this article, we will delve into what open interest is and how it can be used for intraday trading.

What is open interest?

Open interest represents the total number of unfulfilled derivative contracts, like options or futures, awaiting settlement. Unlike tracking the trading volume, it monitors every open position in a specific contract. This metric offers a precise gauge of a contract's liquidity and interest. It distinguishes whether capital inflows into the contract are on the rise or declining, providing valuable insights into market sentiment and potential price movements.

How to use open interest for intraday trading?

Open interest (OI) is a technical indicator that measures the total number of open contracts in a particular security. It is calculated by taking the total number of outstanding derivative contracts for assets such as futures or options, that are not yet settled. Open interest is important for intraday traders because it can be used to gauge the level of interest in a particular security. A high level of open interest indicates that there are a lot of traders who are interested in the security, which can lead to more volatility and price movement.

Understanding volume and open interest

Volume is the total number of contracts that have been traded in a particular security during a given period of time. It is important for intraday traders because it can be used to confirm trends and identify reversals. A high volume of trading indicates that there is a lot of activity in the security, which can be a sign of a strong trend. However, a low volume of trading can indicate that the market is illiquid and that prices may be more volatile.

Price action and its role

Price action is the movement of prices over time. It is important for intraday traders because it can be used to identify trends and reversals. A rising price trend indicates that buyers are in control, while a falling price trend indicates that sellers are in control. A break of a key support or resistance level can also be a sign of a trend reversal.

Tips to use open interest to gauge market performance

• Look for a correlation between open interest and price action: If open interest is rising along with price, it indicates that there is a lot of buying pressure in the market. This is a bullish sign. If open interest is falling along with price, it indicates that there is a lot of selling pressure in the market. This is a bearish sign.
• Use open interest to identify breakouts: When a security breaks out of a key support or resistance level, it is often accompanied by a surge in open interest. This is a bullish sign that the trend is likely to continue.
• Use open interest to identify reversals: When open interest falls sharply after a sharp price move, it can be a sign of a trend reversal. This is especially true if the price move was accompanied by a high volume of trading.

It is important to remember that open interest is just one indicator that you should use when making trading decisions. You should also consider other factors such as price action, volume, and technical analysis.

​Additional read: What is MACD

Open interest example

Let us understand this with help of an illustrative example featuring Ravi, a fictional intraday trader.

Ravi, an experienced intraday trader uses open interest as a key tool in his trading strategy. Ravi primarily trades stock index futures contracts. One morning, as Ravi scans the market, he notices a significant increase in open interest in the Nifty 50 futures contract.

Intrigued by this observation, Ravi performs further analysis. He combines the open interest data with technical indicators and chart patterns. Ravi notices that the Nifty 50 index is trading near a strong support level, and the increase in open interest corresponds with a bullish candlestick pattern.

Ravi interprets this setup as a potential opportunity. He decides to enter a long position in the Nifty 50 futures contract, anticipating that the increased open interest, along with the technical and chart pattern signals, could drive the price higher. Ravi sets a reasonable stop-loss level to manage his risk.

As the trading day progresses, Ravi monitors the market closely. The Nifty 50 index experiences a gradual uptrend, validating his analysis. With open interest continuing to rise throughout the day, Ravi remains confident in his position.

By the end of the trading day, the Nifty 50 index has indeed moved higher, and Ravi's position turns out to be profitable. The increased open interest played a crucial role in confirming the strength of the bullish move and helped Ravi make an informed trading decision.

The importance of open interest

• Market activity gauge: Open interest serves as a reliable indicator of market activity. Low open interest suggests a lack of open positions or that most positions have been closed, signifying reduced interest in a particular contract.
  
  
• Watched closely: High open interest implies that numerous contracts remain open, attracting scrutiny from market participants. This is a clear signal that the market's developments are of interest.
  
  
• Money flow tracking: Open interest enables tracking the flow of money into or out of futures or options markets. Increasing open interest indicates new capital entering the market, while decreasing open interest signals capital exiting.
  
  
• Liquidity insights: Options traders find open interest highly valuable as it provides crucial insights into the liquidity of an option. A higher open interest generally implies a more liquid option, making it easier to buy or sell contracts with minimal price impact.

Conclusion

Open interest is a powerful tool that can be used to improve your intraday trading performance. By understanding how to use open interest, you can identify trends, reversals, and breakouts. This will help you make more informed trading decisions and increase your chances of success.

Here are some additional tips for using open interest for intraday trading:

• Use open interest in conjunction with other technical indicators, such as price action and volume
• Look for unusual changes in open interest, such as a sharp increase or decrease
• Consider the time of day when you are trading. Open interest is typically higher in the morning and afternoon when there is more volatility
• Be aware of the liquidity of the security you are trading. If the security has low liquidity, open interest may not be as reliable

Use Bajaj Financial Securities Limited (BFSL) trading platform to conduct thorough research on open interest and other trading strategies and making safe trades. With a little practice, you can learn to use open interest to your advantage and improve your intraday trading performance.

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