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How to use Open Interest In Options Trading?

open interest in options

In the stock market, the future and options brought a new dimension. In India, options were first introduced on June 4, 2001. Though derivatives in Nifty 50 index futures in the NSE (National Stock Exchange) were introduced on June 12, 2000. Gradually afterwards F&O contracts were introduced and available for trading. NSE also first provided trading in options from July 2, 2001. From November 9, 2001, onwards F&O contracts were available on stocks also. After the introduction of the options contracts, gradually the lion’s share of trading volume shifted to futures trading as well as to the options section. The open interest in options trading plays a vital role in deciding the option’s price movement.

Today the average daily volume in F&O section is around 14.9 lakh crores INR. This is the DAT or the daily average turnover on annual basis. The post-Covid 19 period has an average of 19 lakh crores INR, far above the DAT of the Indian stock market. However, the future and options market runs along with the primary stocks. The futures and options are mere contracts based on the underlying. Hence the price runs alongside, albeit on premium or discount.

And all traders, institutional or retail, always keep close eyes on the open interest in options which governs the price movement. The participants of all types take part in F&O trading. As a result, we find such high volume in derivatives trading.

FAQs

What is options open interest?

Open interest is the total number of active or outstanding contracts or open contracts at a specific time. They can be in both buy and sell contracts. Until the trader exits from positions, the positions will remain a part of open interest.

How much open interest is useful for options?

There is no such number. But high open interest indicates there is good liquidity. When, in a specific day, the open interest increases far above the daily average, we take it as high open intetrest.

Is high open interest good or bad?

There is no answer to that. But high open interest indicates that traders showed high interest in that contract. Therefore the bid-ask gap won’t be high.

What is options volume?

Options volume denotes the number pf trade occured at a point of time. Unlike open interest, volume considers both open and closed contracts.

What is the differences between options volume and open interest?

Both volume and open interest indicate activity and liquidity of a particular contract. Open interest show the number of active contracts that can be traded. But volume measures the strenghth of a particular contract.

Why open interest is so important?

Open intterest data help the traders to gauge the movement of the underlying. Therefore traders show high interest in the movement of open interest data.

Why options are called derivatives?

Options are contracts derived from the price of underlying at a premium for a specific period of time. Therefore they are called derivatives. All contracts in F&O are derivatives.

Price-Volume analysis of Open Interest in Options

Traders can derive a lot from open interest and volume data. Lret su understand first what does these two metrics mean to traders.

Volume of options data

  • The volume indicates the total number of options exchanged between the buyers the sellers in the exchange on a particular day of that contract.
  • Every transaction, whether it is a buying transaction or a selling transaction, counts as volume.
  • Higher volume denotes greater strength of the contract. The more the volume, the more the number of traders fro that contract.
  • More volume means higher liquidity. Short term options traders prefer high liquidity in a contract.
Nifty Option Chain

Open Interest in Options

As already discussed, the open and active contracts at the end of the day show in open interest data. Once the buyer oir seller exits from the contract, the open interest number comes down. Similarly when a trader opens new contract in either buy or sell position, the open interest number increases.

Traders either buy or sell options and increase the open interest number. Writing of options has a similar meaning to selling of options. Option writers are option sellers. A buyer or writer of an option can exit from the position at the market rate or they can hold the option till the expiry date when the contract becomes worthless. A writer allows the options to go worthless to collect the premium received during writing the contract.

Volume versus Open Interest in options

Let us consider an example. A stock XZ has derivatives traded in the exchange. On a particular date, at a strike price of A, a trader buys 15 lots. The open interest becomes 15. One hour later, the same day, he exits the position. So the open interest becomes 0 because there are no other open positions that day. But the volume rises to 15 at the end of the day, because 15 contracts changing hands. This is the most linear relationship between volume and open interest in options.

So we can say when the open interest decreases, the volume increases. Because, the contracts that are closed increases the volume. So if the volume becomes much highrer than the open interest we can say traders the exiting the trades from that contract. This is a big takeaway for the traders.

Takeaway from Open Interest in Futures

  • For futures, in an uptrend rising open interest with rising in price indicates the building of new long positions.
  • Similarly, rising price in an uptrend with falling in open interest indicates the building of new bearish positions.
  • During a downtrend, when the price is falling but the open interest rising indicates that the traders are building new shorts. So there is a stronger chance that the downtrend will continue.
  • Also in a downtrend, when the price is falling along with fall in open interest indicates that the sellers would soon want to sell whatever they had. A selling climax to occur soon.
  • But when at the market top, open interest is high but the prices are falling sharply, the scenario may cause panic selling. It indicates that the traders who bought at the market top are losing money fast and may therefore ensue panic selling. This is also a bearish sign.
  • But for options, we may see different results unlike price movement in futures.

Open Interest in Options Trading Strategies

Take away from open interest in options

Options are unique instruments in the F&O section. Unlike the stocks or their futures, options have different pricing methods. A completely new set of parameters were modelled to fix the price of options. A mathematical model, the Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is considered for pricing of options contracts. The greeks from the BSM model defines the price of options. But the details of greeks do not come under the purview of this topic. We will concentrate on open interest in options for trading purposes only.

Nifty Option Chain (22-01-2021), 10:15 hrs

The open interest at different strike prices shows us probable support and resistance of the underlying. This picture from Options Oracle above shows the Nifty January 2021 series on 22-01-2021. Here, in the picture above, we can see a tall column standing out. At this point of time, this picture shows a high open interest build-up at the strike price of 15000 calls (CE). In an open interest explanation, we presume that the sellers build big positions at different strike prices. These are institutional investors. Basically, their investments drive the market.

The Open Interest Build-up significance

Sellers drive the options market. Because sellers make high investments. The stock market movement always favours the big investors. They are the driving force. Hence options sellers build up positions at strike different prices and decide the range of movements of the underlying. Sellers sell high in options and exit low. Options premium decreases due to Theta and sellers profit big time from this. All OTM options turn valueless after the expiry of contracts. This phenomenon is known as Theta decay. Options sellers profit from this property of options.

So we can say our presumption regarding sellers of options is logically true. Therefore all tall columns show big obstacles. High open interest build-up at puts (PE) show support. Similarly high open interest at CE shows resistance. Hence, in the scenario shown above, we can presumably sell 4 February 2021 weekly Nifty 15000 CE or 15100 CE at the current price and earn the premium at expiry. The most likelihood shows Nifty Future may not cross 15000 within this week.

But the scenario may change. Nifty may move beyond 15000 within this week. In that case, if Nifty doesn’t cross the 15000+your premium mark at the weekly expiry, you are on the safe side. You will earn the profit from this trade.

Similarly, we can find support regions through build-up in put options. A tall column in 14000 PE shows big support zone. Put sellers can write put below 14000 to exploit premium in the weekly series. Though compared to the build-up of open interest in 15000 calls, the open interest in puts is not that strong. So the present scenario also shows that the traders at present think market may slide beyond 14000. But all these are presumptions.

Nifty Open Interest Build-up

Changing OI

The stock market is, by nature very dynamic. Therefore within a moment, the scenario changes completely and sellers take positions at different strikes. With sellers building new positions at different strike prices, the complete market dynamics change. So all other sellers then create new positions. The short-covering happens and we find more active calls and puts at different strike prices.

open interest in options
Change of OI

Now, if we compare the above two images, we will find some interesting things. Both the pictures were taken from stockmaniacs.net within a gap of 10 mins. We can see that the OI scenario has already changed. With small movements in Nifty, the OI changes are already visible. We can see OI are being newly added at different strike prices. This allows us to conclude that options traders trade all the times. They take new positions in a dynamic manner.

But this is not all. I have alrady mentioned earlier that the volume plays a significant role. When option traders shift their position some changes take place. Writers exit strike prices, open interest comes down drastically. But the volume increase at those strikes. This corelation gives us good trading ideas.

When at some strike price open interest decreases and volume increases drastically, above their average values, we can say short covering is taking place. Sellers get trapped at that strike price and shifting position. Short covering takes place there.

Live trading in Options Using Zerodha Kite Chart

On the other hand, when open interest in options increases and price is going below average, we can say traders are building new shorts. At those strike prices, options traders can take a position as sellers. I will show you how you can take a position in options by seeing the live chart.

Zerodha Kite Chart

Kindly look at the chart closely. This is a chart from Zerodha Kite. The picture was taken at around 12:36 hrs. on 22-01-2021. I have shown you how you can trade options using the live charts in Zerodha. This is a 5 min chart in Zerodha Kite. The chart shows the price movement of the 4th. February 2021 call options. In the price chart, there is VWAP. There is also an open interest chart. With open interest, a 20 SMA (simple moving average) chart is also there. I have also added volume with volume 20 SMA. Also 14 days RSI is there.

Now, look at the blue marked portion of the chart. Here the options price has come down below the VWAP (volume-weighted average price). It happened at around 11 AM. See the volume is more than double the average in that column. Open interest has also climbed above its 20-day moving average. The RSI went below the 40 marks. It shows the selling has started on 14500 calls. The price is around Rs 285. The trader can sell 14500 calls (CE) after setting proper stop loss and target. A recommended stop loss would be 20% of buying price and a target of 40%. This trade may earn a good profit for the trader today. But the trader should go out of the trade before the market closes, even if the target or stop loss is not hit.

What are Illiquid Options?

Illiquid options are those options which can not be traded at prevalent market rate. Traders should avoid these kinds of options. When the volume becomes very low, they become illiquid options. In these options, open interest is also at their lowest. So, there are very few open contracts available for options trades. Once you open a contract in illiquid options, it becomes very hard to exit from that contract as long as they remain illiquid. But if due to sudden price movement of the underlying, these options attract traders, then they do not remain illiquid any more. So they are traded like others. At times, traders prefer buying illiquid options. they buy illiquid options of far contracts to gain high profit assuming the underlying price will move near the strike price before contract expiry.

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