Understanding open interest

COMMODITIES TRADING

Open interest position in a commodity exchange means the number of unclosed contracts entered into on a particular day.

Since all the three commodity exchanges "" Multi Commodity Exchange of India (MCX), National Commodity & Derivatives Exchange (NCDEX) and National Multi-Commodity Exchange of India Ltd "" have different sets of open interest positions in different commodities, investors tend to misinterpret the concept.

There is considerable debate over the importance of volumes of trading on a commodity market. Higher growth in volumes could result from 'circular trading' where participants add up the volumes by buying and selling at the same time.

This pushes up the volume without the transaction being a real one. The concept of 'open interest' becomes more important in this context.

But, what then is an open interest position?

By definition, the total number of options or futures contracts that are not closed or delivered on a particular day is open interest.

Open interest reported on a day represents the increase or decrease in the number of contracts for that particular day. It is shown as a positive or negative number.

A common misconception among investors is that open interest is the volume of futures trades. The following example will make this concept more clear. Let us assume that on day 1, A buys 1 futures and B sells the same.

In such a case open interest, at the end of the day would be 1. Suppose on day 2, C buys 10 futures from D, then the open interest rises to 11. If A sells his 1 futures to D on day 3, then the total open interest would come down to 10. On day 4, if E comes in and buys 10 futures from C then, open interest would remain at 10 as E is only replacing C.

Carrying this concept further, the ratio of open interest to volume traded could also give an idea of the true level of activity on the exchange as it juxtaposes the actual interest with the volumes being traded.

It is also important to note that open interest must be understood from only one side and must not be double counted (as there are two parties involved in such a transaction).

Open interest is also used to indicate the trend and trend reversals for futures contracts. An increase in open interest along with an increase in price is said to confirm an upward trend. If prices are rising and open interest is increasing at a rate faster than its five-year seasonal average, this is a bullish sign.

This means that more participants are entering the market, involving additional buying and purchases are generally aggressive in nature.

Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remaining flat or declining may indicate a possible trend reversal.

If the open interest numbers flatten following a rising trend in both price and open interest, this can be interpreted as a warning sign for an impending top.

High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many 'weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral.

An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, we can expect a bearish trend.

Therefore, the concept of open interest is of critical importance in the context of futures markets as they are indicative of the state of things to come, besides reflecting the genuine volumes on the exchanges.