How to use OI to add confidence to trading at the top

F&O Cues

Buying or selling when the market is at the top or hits the bottom is scary and requires confidence. When we are buying at the top we need that extra bit of confidence that the rally is not done. To improve the confidence, we can make sure that we are not following hollow price moves. One data point in futures segment that helps is open Interest (OI).

Let us first understand what OI is and then figure out how can it help in boosting our confidence. OI is the number of contracts open in a particular instrument. Futures contracts are fictitious (not tangible like equities). To measure it, one needs to create some sort of accounting. This accounting is called OI. One Buyer + One Seller create One contract = One OI.

Now, let us see how OI can help. We all know that price has most of the information about the sentiment and can tell the bias. However, when we put the OI up and down along side the price move in a future contract, we get to know something extra.

If the OI is going up, it means more buyers and sellers are coming into trading that futures or options contract. If OI is going down, it means traders are exiting the futures contract.

Now let us add price change to this. Even though the contract is created by a new buyer and a new seller coming together, between the two, one has weaker bargaining power.

Due to this, if a buyer has weaker bargaining power, they will buy at even a higher price. Similarly, if a seller’s bargaining power is weak, they will sell at a lower price.

Why? Well, when you are expecting Rs 100 stock to go up to Rs 110, you are okay paying 101 but would want to enter before it’s too late. Similarly, when you are expecting Rs 100 stock to fall to Rs 90, you want to sell it as early as possible even though it means selling at Rs 98.

Thus, weaker bargaining power offers an insight into how is the price movement likely to be.

If we summarize, we can understand that with increment in OI (Initiation Trade) if the price rises that means there are new buyers who expect the price to go high. Hence, we label it as projecting bullish bias. Similarly, price going down with OI going up means sellers are initiating with firmer expectation of a bigger drop, projecting a bearish bias.

This confidence booster can happen the other way round also. If there is fall in OI alongside fall in Price, it means closure of contracts by sellers (weaker bargaining power). Since you need to buy before you close, we can term them as long unwinding (buyers exiting). Similarly, price up + OI down would indicate sellers exit.

So, just by adding OI to price move we can figure out if traders are creating fresh trades or exiting. This can help boost confidence at the top in trading a price move.