Basic Concept of Open Interest and Volume

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Open Interest and Volume - Fincareplan

 

Derivative traders have confused about the terms open interest and volume of the particular stock, let me try to simplify the answer in a simple way. Before going to analyze the open interest data. First, clarify the volume.

Volume plays a crucial role in technical analysis and tries to find out the direction or trend in the market. It indicates how many shares are bought and sold over a period of time.

For example, you decide to buy 1000 shares of Yes Bank at 18 and I decide to sell 1000 shares of Yes Bank at 18. There is an exact match of bid and offer price of buyer and seller, which results in a trade.

Tell me, what’s the total amount of volume in this trade, many people count the volume as 2000 (1000 buy + 1000 sell). It’s not the correct way to look at the volumes, remember one thing you and I together have created 1000 shares of volume in Yes bank share.

We know the volume of shares traded on that particular day, how to use the volume data in trading, simply traders check the volume of preceding 20 days to identify the volume trend and take a confirmation of the trade.

 

PRICE

VOLUME

DEFINITION

Increase

Increase Bull trend

Increase

Decrease

Bull trap

Decrease Increase

Bearish

Decrease

Decrease

Beartrap

 

Don’t make it confusing, simply remember whenever the volume increase exponentially in any particular stock that means institutional investors buy the stocks heavily in case of increasing price trend, the same way, they offload the stock when price decreasing continuously.

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Kindly check out the article on the Peak Margin rule by SEBI

Key Takeaways – Open Interest and Volume:

 

  • Volumes are used to identify the trend
  • Total volume indicates the cumulative volume of the day
  • High volume indicates the presence of institutional investor
  • Low volume indicates the retail participation
  • Traders take the position when volume confirms their trend.
  • It’s better to avoid trading on low volume days.

 

Let us have a look at the most confusing part, we need to the patient while understanding the flow of open interest otherwise you will get frustrated.

 

Open interest is the number of outstanding contracts presently held by the market participant at a given time. It tells the number of future and option contracts that are currently open in the market.  Let’s make it interesting, each trade completed on the exchange has created an impact upon the open interest data for that day.

 

Let’s take a hypothetical example to understand the whole picture. There are four participants in the market namely Rahul, Ravi, Shankar, and Vikram. For example, Rahul buys 5 futures contracts and Ravi buys 5 futures contracts of Nifty, while Shankar sells all of those 10 contracts. After this transaction, 10 contracts are long side and another 10 contracts are short side. Hence the open interest is 10. We have to make three rules for further understanding

 

Rule 1:

One new buyer + one new seller =>   open interest will increase by one contract.

 

For the above example, the fresh buying contract is 10 and new selling contract is 10, and open interest also 10.

 

For the next day, Shankar wants to square off the 8 contracts out of 10 contracts he holds, which he does. Vikram comes into the market and takes on the 8 shorts contract from Shankar. We must understand that this transaction did not create any new contracts in the market. It was simply transferred from one person to another and open interest will remain 10.

 

Rule 2:

One old buyer sells à one new buyer bought = open interest will not change.

For the above example, among the four market participants, Shankar is an old buyer (holding nifty future short position) sell his contract to the new buyer Vikram.

 

Rule 3:

 

If both the traders are closing an existing position or an old position (one old buyer and one old seller) open interest will decline by one contract.

The open interest information tells the number of open positions in the market. Just look at the following snapshot.

Nifty 50 Index Derivatives - Open Interest and Volume

 

As of 12th December 2020, Open Interest on Nifty future is roughly 1.25 Crores. It means 1.25 cr long positions and 1.25 cr Short Nifty positions. Also 1, 94,250 new contracts had added (1.58%). An increase in the open interest means more liquid in the nifty future contract.

 

Let us understand a few terminologies related to the open interest change.

TERMS

PRICE OPEN INTEREST

DEFINITION

Long buildup Increase Increase More trade on buy-side
Long unwinding Decrease Decrease Longs cover their trade
Short buildup Decrease Increase More trade on the short side
Short covering Increase Decrease Shorts cover their trade

Kindly check our article on the India VIX Volatility Index Share price review.

 

Conclusion:

 

 

  • To understand the difference between volume and open interest in the market
  • These open interest numbers are meaningless in illiquid option
  • Analyze the Open Interest number in Nifty, Bank Nifty, and top liquid stocks of the current month expiry.
  • Do not trade based on these numbers only. Analyze some other facts and economic data, before entering the trade

 



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Fincare Plan

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