“Open interest is like a puzzle – it may seem confusing at first, but once you put the pieces together, you can see the bigger picture of the market.”
Both volume and open interest are relatively useless on their own. Volume today doesn’t predict tomorrow’s volume, but open interest can. Unlike volume, changes in open interest don’t indicate market direction. Open interest does show a balance of bullish and bearish positions.
Before We discuss Open Interest, We need to talk about the relationship between price and volume. Here are the four possible combinations of price and volume:
Price Up, Volume Up:
Price Up, Volume Down:
Price Down, Volume Up:
Price Down, Volume Down:
Table 1: Relation Between Price And Volume
Open Interest Theory
Bullish pressure is decreasing.
Bearish pressure is decreasing.
These four combinations of price and volume should be used in conjunction with other technical analysis tools to make informed trading decisions.
Interpreting open interest data in conjunction with price can give traders important insights into market sentiment and potential trends. This assumption collectively is known as “The Open Interest Theory”. There are four possible scenarios to consider when analyzing open interest and price movements:
Rise in prices and rise in open interest:
Rise in prices and fall in open interest:
Fall in prices and fall in open interest:
Fall in prices and rise in open interest:
Table 2: Relation Between Price And OI (Open Interest)
While open interest and volume are useful indicators in many cases, they may not always provide an accurate picture of market activity. Here are a few examples of situations where these indicators may not be effective:
The stock market is not only about numbers and financials, but it is also a psychology play. The behavior and emotions of traders and investors can significantly impact stock prices. The market is driven by fear, greed, optimism, pessimism, and other psychological factors.
Open interest is a useful tool to gauge herd mentality in the market.
Let’s take a quick glance at all the jargon in a table format, shall we? While it may seem unnecessary to reiterate the same information, it is crucial to have clarity when dealing with complex concepts.
Confusion can easily arise later on, so it’s better to communicate ideas and jargon clearly from the beginning.
With respect to call options, the four cases are:
Call Long Buildup
Call Short Buildup
Call Short Covering
Call Long Covering
With respect to put options, the same four cases apply, but the interpretation is opposite to that of call options:
|Put Long Buildup||Increase||Increase|
|Put Short Buildup||Decrease||Increase|
|Put Short Covering||Increase||Decrease|
|Put Long Covering||Decrease||Decrease|
Now, Let’s look at the scanner made on the website of Unofficed.com for a real-life example –
If we just take the separate examples of Call Options and Put Options, the interpretation looks easy.
As in this case, there is a Loss in Put OI in Reliance. Now, We need to check the price of the underlying i.e Reliance. As we can see from the Tradingview snapshot of the Daily Timeframe of Reliance, Reliance ended up in green. It means the Price increased.
So “Price Increase + OI Decrease” means Short Covering.
But, Call Options have their Open Interest reduced as well. So, We have both “Put Short Covering” and “Call Short Covering”.
In other words, if a trader only focuses on “Put Short Covering” and ignores the interpretation of Call Open Interest, they may not have as much of an advantage as a trader who considers both factors.
Do you agree?