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Using Volume And Open Interest When Trading Fut...

Open interest is a very good indicator of the investor activity in a stock/index. In contrast to the daily volume whose increase or decrease is not directly correlated to the strength of the move, the open interest is a direct measure of the strength of the move in a market. To explain further, if a rally in the price of a stock is associated with an increase in open interest then you can be certain that new positions have been added or that there is a renewed interest in the stock/index. This is an indicator that can easily be used in Futures and Basics of options trading. Today let us try to build an Open Interest Trading Using Python to check some basic assumptions about what open interest indicates. This blog is an introduciton to option trading for dummies.

Using Volume and Open Interest When Trading Fut...

First, let us pull the data of a stock/index and verify the open interest from this open interest data. Let us pull the futures price of the stock SBI (State Bank of India) and check the trend in its price and open interest. It is common for a stock to increase its open interest when the contract becomes active or front month. Conversely, as the stock approaches expiry its open interest decreases. So, to check if the open interest of the futures is increasing or decreasing, we will have to take the combined open interest of the front and second-month futures contracts. This will give you the complete picture and avoid any abnormality during the contract rollover.

Now let us analyse how the stock traded and if there was an opportunity for us to trade in this combined Open Interest chart. First, let us put these two charts together then you can see that the combined OI (open interest) starts to decrease well before the expiry, but the price keeps increasing. This is generally considered a bearish signal, as it indicates the fact that either of the traders is winding up their positions or beginning to short, and hence the open interest is decreasing. This leaves us with a good shorting point just before the expiry, when the divergence increased significantly. I will leave you with a small but important table that will help in identifying the strength of a trend.

Let me illustrate OI with an example. Assume the market consists of 5 traders who trade NIFTY futures. We will name them Arjun, Neha, Varun, John, and Vikram. Let us go through their day to day trading activity and observe how open interest varies. Please note, you need to exercise some patience while understanding the flow of events below, else you can quite easily get frustrated!

Open interest information tells us how many contracts are open and live in the market. Volume on the other hand tells us how many trades were executed on the given day. For every 1 buy and 1 sell, volume adds up to 1. For instance, on a given day, 400 contracts were bought and 400 were sold, then the volume for the day is 400 and not 800. Clearly volumes and open interest are two different; buy seemingly similar set of information. The volume counter starts from zero at the start of the day and increments as and when new trades occur. Hence the volume data always increases on an intra-day basis. However, OI is not discrete like volumes, OI stacks up or reduces based on the entry and exit of traders. In fact for the example we have just discussed, let us summarize the OI and volume information.

In Figure 3a,b we present growth rates in volume and open interest for futures and options combined, respectively, for each geographic region. In Figure 3a, for the three larger regions (North America, Asia, and Europe), we observe somewhat similar comovements during the pandemic period. The other region, Latin America, differed somewhat with a small initial spike in volume in 2020 followed by a pattern of continued growth through most of the remainder of 2020. In Figure 3b based on open interest, again with the exception of Latin America, the growth during 2020 is fairly flat to modestly positive and again similar across regions.

Whilst $700M is a large sum, exchange withdrawals pale in comparison to the recent peaks of $3B+ per month, and also in comparison to the $6.6B in options open interest. Monthly exchange withdrawals today are just 2% the size of futures trade volume, whereas this ratio reached over 20% in April 2022 and November 2021.

If you are interested in liquid markets, the Nifty is for you. Liquidity is never a major challenge for the Nifty futures as it is one of the most liquid contracts but there are occasions when the Nifty futures can get into your liquidity trap. Firstly, on the expiry day you will normally find the volumes on the Nifty futures vanishing once the rollovers are substantially completed. Also, in a market that is falling very sharply, the spreads can widen substantially increasing your risk in trading Nifty futures.

This is an interesting aspect of Nifty futures trading. When you are buying Nifty futures then there is another party that is selling and the same logic applies when you are selling Nifty futures. The other party could be a trader or a hedger and the open interest data will give you necessary insights. While you are normally driven by your view on the Nifty, it always pays to understand the counter view as it can give you greater clarity in your Nifty view. Here, one must know 8 things to remember when trading in Nifty Futures 041b061a72


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