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Infer consensus using Options open interest: Shubham Agarwal

Open Interest as the word suggests is the amount of interest in any derivatives instrument. The Indian equity derivatives market has two kinds of instruments Futures and Options, where Options have further 2 varieties Call and Put.

SHUBHAM AGARWAL | 11-Dec-21
Reading Time: 3 minutes

undefinedOptions offer a lot of convenience to traders with its inherent characteristic of having limited loss and much higher potential profits for the Buyers of the options. However, the trade data of the options also holds a lot of information. Especially Open Interest data which accounts for incoming and outgoing participants.

Open Interest as the word suggests is the amount of interest in any derivatives instrument. The Indian equity derivatives market has two kinds of instruments Futures and Options, where Options have further 2 varieties Call and Put.

Now, while with the stocks there is a finite number of equity available and can be accounted for against their physical (now electronic) availability for trading, with derivatives, such accountability gets generated by the total number of fresh contracts created. This does not necessarily mean the total number of Buyers and Sellers. In this sense it is different from Volume

Let us understand with the help of an example.

Mr. X Buys a Futures Contract, Mr. Y Sells a Futures contract.

Volume = 1, Total OI = 1

Then, Mr. A Buys a Futures Contract, Mr. B Sells a Futures contract.

Volume = 2, Total OI = 2

Afterwards, Mr. B Buys back the Futures contract and Mr. X Sells his Futures Contract.

Now, Volume = 3 but Total OI = 1

This is because one of the futures contracts got unwound.

That sums up the brief on what is OI (Open Interest).

Now, this same example holds the essence of the analytics hidden into OI numbers as well. Despite a heavy volume activity only increment in OI will give us reasonable evidence of incremental trading interest into a particular stock. Similarly lowering OI will signal loss of trading interest into a particular stock.

As empirical evidence has it, increment in open interest has a lot of time been followed by movement in the underlying stock/index. This has been more evident in the future and gets tossed around as a reason for movement by many analysts.

Similar, attention should be paid to options. Here, there are a few challenges. There are multiple options in terms of type and strike. Also, the inference may not be so straightforward. Let us simplify this by following a few simple steps of observations and we should be a good start.

1. Directional Bias:

What are we looking for?

• Options with a strike price close to the current market price of the stock/index with unusual incremental change in open interest (anywhere more than 10%-100%).

• Underlying stock or index moderately moved (nothing out of ordinary like 10%, 15%, 20%)

• No event in immediate future (2-4 trading days)

Inference:

If we see a combination of such observations and if the option type is Call, such underlying stock/index has been empirically seen going up immediately after that.

If we see a combination of such observations and if the option type is Put, such underlying stock/index has been empirically seen going down.

2. Support & Resistance:

What are we looking for?

Highest Open Interest of Call & Put of any stock/index that we want to trade to trade

Inference:

Oftentimes the Highest Open Interest among Calls is in the strike higher than the current market price of the stock/index that belongs to and for Puts it is the strike lower than the current market price.

Basic premise here is that more Open Interest = More Writers and More Writers = Consensus over their strike being held and not crossed over.

Utility is very simple. If our price objective is beyond this band of Highest Call/ Put strike, it makes sense to rethink our trading objective.

These are some of the known and most used inferences of options Open Interest data. This could be helpful in identifying a trading opportunity as well as supporting a trading argument.

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SHUBHAM AGARWAL is a CEO & Head of Research at Quantsapp Pvt. Ltd. He has been into many major kinds of market research and has been a programmer himself in Tens of programming languages. Earlier to the current position, Shubham has served for Motilal Oswal as Head of Quantitative, Technical & Derivatives Research and as a Technical Analyst at JM Financial.

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