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Open interest analysis can help traders get a sense of whether new people (read money) are entering the market or not. This knowledge ultimately helps in speculating if market is gaining strength or getting weaker. Now before moving ahead, let's quickly understand what Open Interest is?

Open Interest basically means positions which are open or outstanding and not yet squared off.

Beware that OI is cumulative while volume is not. While volume resets each day, OI gets carried forward to the next day till expiry. Additionally, Open Interest gives vital information with respect to market trends, liquidity and could be used to earn profits from futures and options markets.  As we deal in primarily 2 types of derivative contracts namely Futures and Options, the total number of outstanding contracts will naturally differ across these two markets - hence should be studied independently. There are certain logical rules related open interest that traders must understand and remember while trading so as to avoid being on the wrong side of the trade. The rules are summarized in the table below:


Price OI Meaning
Up Up Market is strong - Bullish
Up Down Market is weakening - Getting Bearish
Down Up Market is weak - Bearish
Down Down Market is getting strong - Getting Bullish

To gain further insights into logic behind these interpretations, I would suggest you to go through these nicely written article here, here and here. However here is a quick explanation.

Remember that for each buyer you need a seller. Same with FnO contracts. Let's think of the first contract which was opened. At the moment when a buyer and a seller have been matched, we have one open contract (i.e. one open interest). However, we still do not know or can predict which way the underlying price will move. Either of the buyer or seller can be right in his assumption of future price move. Here enters the new money i.e. one more contract is opened between new set of buyer and seller. But this time let's say the price of contract was slightly higher as compared to the last contract. So now we have 2 open contracts with second buyer being more aggressive (bullish) than the first one. Let's extrapolate the same logic to 100 open contracts wherein every new contract was opened at slightly higher price than the previous one. So the overall picture is like - OI is increasing and price is also rising - which in turn means market is strong and bullish. The same analogy can be applied while every new buyer is paying smaller price than the previous contract and we will reach the conclusion that market is weak and bearish. 

If more people become “interested” and are willing to pay market price for their order execution, it can foretell what smart money expects and wants.

This patters has more significance especially immediately before a new trend or during strong trends. An increase in Open Interest indicates that a breakout or breakdown is likely and the trend will strengthen further. Trend will initially be self feeding as most of the traders who are on the wrong side of the trade will cover their position. Now, try not to get fooled by sudden dip in OI just after a sharp price movement as this dip might be because of people covering their positions in panic. Once this panic phase is over, trend followers will jump in to fuel the next leg of the trend where in OI will again start increasing in the direction of the trend. If you do not observe this pattern, then time to be cautious as it could be a false signal.

Now, let's get back to the original question - how to identify if money is flowing into the market or moving out of it i.e. if the the market is getting strong or weak. To ascertain that, lets plot the combined Open Interest (across all expiry) and Price chart for Nifty futures. 

If open interest is rising, then the participation (new money) is definitely increasing in market. Keep in mind that rising OI signifies that new money is flowing in, however it does not tell if the new money is bullish or bearish. The bullish or bearish nature of new money could be well established studying the price action along with direction of change in OI. Use the above chart to analyse OI and price relationship and refer to the rules presented in table above to decipher if market is getting bullish or bearish. After studying the futures OI, lets turn our attention to Nifty Option Contracts OI. Is the open interest of options contract telling the same story? Let's plot the chart and see.

To understand the true nature of the new money in a bit longer time frame, let's have a look at the price and volume relationship too. Generally speaking:

  • In a bull market, volume tends to increase on rallies and decrease on reactions.
  • In a bear market, volume tends to increase on declines and decrease on rallies.
  • Trading volume usually increases dramatically at market tops and bottom.

Here is the plot of Nifty Future Contracts volume and price. Analyse and establish if volume is speaking the same language as OI or not.

And here is the plot of Nifty Option Contracts volume and price to understand whats happening in the options market. 

Try to figure out the price volume relationship to build on the information you gathered about bullish or bearish nature of new money from OI analysis above. If OI, Volume and Price are pointing in the same direction then the golden rule to follow is not to be on the wrong side of trade. Refer to the table below to interpret and act on the conclusions you have drawn from above analysis:


Price OI Volume Interpretation/Strategy
Up Up Up Avoid shorts and look for buying opportunity
Up Down Down Avoid longs as indicative of trend reversal
Down Up Up Avoid longs and look for selling opportunity
Down Down Down Avoid shorts as indicative of trend reversal

 

All the knowledge which you gained from above discussion, can be applied as is to any other indices or stock. You can explore how other stocks are placed with respect to Price, Volume and OI parameters below: 

Plot Price, OI, Volume Chart of Stocks


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Is the Banknifty data pointing in the same direction as Nifty?

We have plotted the same charts for Banknifty as that of Nifty above. Do analyse and check if Banknifty data is telling the same story as Nifty. Broadly speaking, if both the indices data analysis is leading to same conclusion then you should be more confident about your view, which in turn means you have some extra leg room with respect to your risk appetite. However, if the data analysis leads to opposite view on direction of movement of both indices, then you need to be extra cautious with your positions. May be it's better to look for a pair trade opportunity in the two indices. Know more on pair trade analysis here.

Does the overall Market data pointing in the same direction as Nifty and Banknifty?

So you have seen Nifty and Banknifty charts. What about the stocks. Here is the same plots as above for all the stocks futures and options. The data plot is for aggregated OI and volume of future and option contracts of all the stocks under FnO segment (you can plot the data for individual stocks above). We have not plotted price as we can not assign a single price to group of stocks. Having said that, just for analysis sake, you can take Nifty level as reference. Again broadly speaking, if overall data for FnO stocks confirms to the view on Nifty and Banknifty, then the level of confidence in once view should increase further. And if not then there might be something fishy which in turn increases the probability that trend might reverse on Nifty and Banknifty. Does the word Index Management ring a bell?

Caution:

So you now know how to analyse Price, OI and Volume data, however it's not advisable to jump directly into trading based on conclusion you draw about market strength from above analysis. Let the information sink in first. Spend some days studying the charts and identify if this logic works and market behaves in the way you expect it to behave (not all the time but most of the time). The next step is to start with some paper trading based on your assumptions about strength and weakness. Once you are comfortable, you can start taking smaller bets in the market and grow from there. And above all, do not expect the market to behave as you want in short term. Even though your analysis is correct, never ignore the famous quote:

The Market Can Remain Irrational Longer Than You Can Remain Solvent

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