Shubham Agarwal
Data analytics has caught quite a fancy in recent times and our market is no different as we have new prices and volumes getting recorded more than once a second when the markets are open. While Volumes apart from the price has been quite closely watched, Open Interest with respect to trade data of Futures and Options have been gaining more and more attention in recent years.
Out of personal experience this one piece of data when conjoined with Price moves has always helped me gauge the market consensus more effectively. Ultimately, it is the consensus that drives the market.
Let us discuss first what this Open Interest is and then let us try and figure out the utility of this data for analysis of market expectation of direction.
Open Interest as we all know is nothing but accounting of total number of contracts outstanding as on that time in particular instrument. Having said that unlike volumes every new Buying and Selling may not account for fresh Open Interest.
Meaning, Mr. A Buys instrument X, Mr. B Sells instrument X and one lot of open interest is created. Now with the next transaction 3 things can happen:
1. Mr. C wants to Buy one lot of instrument X, and Mr. A Sells it to Mr. C. This accounts for additional transaction with the Open Interest remaining the same as no new contract was created
2. Mr. C wants to Buy one lot of Instrument X and Mr. D comes along and Sells instrument X. Thereby, now having 2 transactions between 4 parties and creation of yet another contract. Open Interest turns 2.
3. Mr. B who earlier sold wants to Buy back instrument X and Mr. C agrees to Sell it. Here the new transaction takes place between some of the parties squaring off their original positions. This would lead to unwinding of that 1 lot open interest, making Open Interest back to 1.
Out of all these 3, most of the transactions would fall under situation #1. But situation #2 & #3 are the ones which we are more interested into. Situation #2 especially where there was open interest addition. The reason why this is helpful is because it is indicative of the fact that there is additional trading interest in the underlying with fresh directional expectation.
We can now go on to associate Price to the Creation & Unwinding of open interest, which will help us have 4 different combination of derivatives data.
Now considering the instrument under question is Futures. Let us see what we could imply out of each of these 4 combinations.
If Price is Up and Open Interest has also Increased, isn’t it safe to assume that the Buyer had lower bargaining power in creating positions? In other words, if I am expecting Stock X at 100 to go up to 110, I wouldn’t mind Buying it at 101 as at this moment the position creation is more essential than hunting for bargains.
This means that whenever we see Price Up and Open Interest added, it could be inferred as additional bullish bias added into the stock. Similarly, with the same logic the setup other way around also can be justified. Whenever we see Price Down and Open Interest added, it could be inferred as additional bearish bias added into the stock.
In case of unwinding, the open interest is in reduction mode. Alongside it if we see reduction in Prices, could actually mean that pressure from sellers was higher. Now who would be Selling to unwind their position? Answer is one who has existing Longs.
Thus, we could conclude reduction in both Price and Open Interest could be labeled as Long Unwinding and on the flipside of the same logic, Increment in Price with Reduction in Open Interest could be seen as Short Covering.
Finally, once we have established that either the stock/index futures have been adding longs, shorts or unwinding longs or shorts directional inferences are rather simple
Long addition can be looked at as creation of Bullish expectations, Short additions could be inferred as creation of Bearish expectations. On the other hand, Long Unwinding could be taken as an indication of reduction on bullish bias or Bullishness turning Neutral, while with Short Covering the indication could be reduction in Pessimism and expectation of a Respite if not a Reversal.
Longs and Shorts could back up our trade creation rationale, while Long Unwinding and Short Covering could back up our Profit Booking
Rationale.
Ultimately, no science has been proven capable enough in long term of predicting the direction of any stock or index but yes, Option Interest Data Analytics can certainly give us a closer look at the consensus expectation in the making. OI data can certainly give an edge to directional analysis.
(The author is CEO & Head of Research at Quantsapp)
Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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