Outstanding Issues

Open interest numbers can provide useful insights to a trader

Does interpreting outstandings help traders? Well! If you knew the answer you would have never asked the question. The answer has utmost significance for a trader.

However, the importance doesn't make the interpretation of outstandings complicated. They are easy to interpret. Higher the outstanding figure, more the interest in the current price. The vice versa is actually not true, as sometimes what might be perceived by markets to be insignificant can be a kill.

It's just that this parameter of the derivatives market only tells us about what the market is aware of and not otherwise. Now this interpretation, I am sure is not tricky, as even if the trader knows what the market knows, he can increase his chances of making money.

 

Outstandings tell us the interest and exposure that a trader has in the market. This is the reason outstandings are referred to as Open Interest. Open Interest is basically the cumulative figure of all running derivative contracts i.e. the number of derivative contracts that at any given point of time have both a buyer and a seller. Open interest increases as more fresh positions are taken on both long (buy) and short (sell) side of the market and decreases as traders square off positions.

There are numerous traders in the market transacting around 0.1 million contracts daily. However, to explain how outstandings are generated we can take an example of three traders transacting between themselves. For every long (buy position) you need a short (seller). Three scenarios can depict Open Interest.

First: Trader 'A' wishes to buy three Nifty futures contracts. He needs couterparties to sell those three contracts to him. Let us assume that trader 'B' sells those three contracts to A. Now, once the trade is over, Open Interest for the market goes up by three. There is a completely fresh transaction that takes place on both the buy and sell side.

Second: If 'B' decides to square off to book profits (losses) he needs a counterparty again. And since 'B' is squaring off, he needs to buy back his Nifty futures (all square off are done by offsetting trades). Suppose 'C' gives 'B' the counter trade by offering to sell three Nifty futures. This transaction is not a fresh one, as 'B' is getting out of the market while 'C' is getting into a fresh trade. Such trades never add to the Open Interest of the market and hence Open Interest remains unchanged, as illustrated in the grid.

Third: It's only when both 'A' and 'C' plan to exit trades - i.e. have no exposure in the market - that the Open Interest reduces. In such a case there is a complete square off from both sides. Both the buyer and seller exit the market together by reducing respective exposures. It is in such a scenario that every one unit of complete square off reduces Open Interest by one unit.

Hence, whenever Open Interest increases traders should understand that trading is increasing in the market and vice versa. Declining Open Interest is a sign of positions being squared off for profit booking or for cutting losses. Traders should keep such basic thumb-rules in mind before taking positions in the derivatives market. Taking a position, say for example in Nalco, BSES, Hindalco and HDFC futures today, is going a bit against the trend as their outstandings are less than one per cent of the total futures outstandings. The outstandings can be less owing to many reasons - lack of depth and lack of view being some of them. But simply putting it...higher the percentage of Open Interest, better the interpretation of buying and selling trends and vice versa.

We did a little number crunching to highlight the Open Interest percentage in the futures market. Open Interest for the futures market as on February 14, 2003 stood close to 78000 contracts compared to the 58000 of daily traded volumes. On the face of it this gives a clear indication that the number of day traders are less than the number of traders willing to carry-forward their exposures beyond a day. And the second indication is that the derivatives market iscoming of age where traders are willing to take overnight risks; 78000 contracts were carried forward from Friday to Monday. Interpreting it further, 78000 traders (assuming one trader transacts a solo trade) are hopeful that futures will rise on Monday and vice versa. We will discuss later on how to know whether it's the long or short side you should be in. But the fact that there are 78000 more traders in the market reinforces your long or short view that a trade is well begun.

Filtering it a bit further, 72 per cent of all the 78000 trades on Friday came from merely 12 stocks (excluding Nifty). Nifty had the largest chunk of 14 per cent of the futures