What Is Open Interest and How Does It Work?

Market Traders have to consider a lot of factors on which the price behavior of a security or stock depends, before entering a trade.

They study technical charts, technical indicators, market trend and current sentiment in the markets.

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Another factor which plays an important role in determining the future price behavior of a security is Open Interest in stock market.

Before studying the impact of Open Interest on stock prices, we should be clear in our minds if what is Open Interest.

What is Open Interest ?

We can define Open Interest as the total number of contracts in Futures or Options that are open in a trading cycle.

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In markets, there is buyer and a seller. Both make a trading cycle.

A trading cycle initiates when a buyer (A) buys a contract from a seller (B). This contract is open now. This means open interest is build.

When the buyer (A) sells back his contract to seller (B), the contract is closed. We say that a trading cycle is completed. Now the open interest is closed.

Now it is not necessary that A shall close his trading position by selling to B only. ‘A’ may sell his position to third person C. Here the contract is not closed but has been forwarded.

Now ‘A’ is out of trading cycle but ‘B’ and ‘C’ are there with open contract which they shall need to close to come out of market.

Now we understand that Open Interest shows the trader’s activity in any particular security.

The build up or reduction in Open Interest is indicative of imminent future price movements in that particular security.

Being a trader, you must have heard technical analysts talking about Open Interest activity on televisions.

Interpretation from Open Interest activity

Changes in Open Interest along with the change in market price of a security is seen in 4 patterns ;

Increase in Open Interest

Increase in Open Interest along with increase in market price of the security suggests that the traders are bullish on that security and expect prices to go up in near future.

Prices go up when buyers are ready to buy the security at a price the seller is willing to sell. Seller shall definitely want to sell on higher prices as he/she is there to make a profit. This situation is seen when Long Build Up is there.

Increase in Open Interest along with fall in market price suggests that the traders are turning bearish on that security. So prices are likely to fall further in near future.

Here the trader wants to exit the market at best possible price. So seller shall be selling the security at a price the buyer is willing to pay.

Any buyer wants to buy at lowest possible price. So prices start falling. In this scenario, we say that Short Build up is created.

Decrease in Open Interest

Decrease or closure in Open Interest along with increase in market price of the security suggests that traders who created Short Build up are exiting their positions.

These traders want to exit out of their Short positions quickly as rising security prices are putting them into losses.

So they will have to close their positions by buying back at seller’s price. This further accelerates the increase in security price. That is why Short Covering is very fierce.

Decrease in Open Interest along with fall in security price interprets that the traders who have created Long Build up are coming out of their Long positions. These traders are no more bullish now on that security in near future.

Open Interest Analysis

The below table shows the open interest analysis in different situations. Keep it in your mind, always, to have an idea about the price action in near future.