Open Interest (OI) is the sum total of the outstanding positions that need to be set off before or on expiry. Open Interest gives an indication about the strength of a price move and the trend of the market.
Changes in open interest may confirm price action or act as a warning of a potentially weakening trend. However, Open Interest in any derivative contract cannot exceed the market-wide position limit set by the exchange. A market-wide position limit is the maximum number of open positions allowed in any F&O contract of an underlying security.
A trader can take use Open Interest to read the market trends. The Open Interest depicts the true picture of the futures market better than volumes.
Both index futures and stock F&Os can be easily understood by tracking Open Interest. Simply put, when Open Interest increases, it means more money is moving into the futures contract, and when open interest drops, it means money is moving out of the contract. One can draw inference from this example.
Consider a rocket, when it has enough fuel, it will keep going up, but when there is no fuel, it can’t go too far. If the market is showing strength, then a trader can create or carry on with long positions. In the same way, we can interpret rising Open Interest in a falling market to be an indication that the market is getting deeper into the bear grip, in which case short positions can be created or carried forward.
Shedding of Open Interest in a particular contract signals end of a prior trend, leading to positions getting squared off. When the market is in a rising trend, the bulls get excited, while a falling market excites the bears. This is a signal to the traders to exit from their positions or cut exposure to the futures market.
In a few words, one can say that every future trader must follow the Open Interest in futures as well as options contracts to understand and predict the future movement of an underlying.
If you can read Open Interest data in the futures market right, it becomes easier to get a sense of market sentiment, interest and liquidity. Besides, it can also help catch momentum opportunities and better decide market timing on trades. Undoubtedly, a trend can be defined by upward and downward price direction, even though the sustainability of such trend is questionable.