1. What is open interest?
An outstanding buy or sell position on a stock or index futures or options contract.
A trader can gather cues from open interest (OI) to spot potential trends in a stock or in an index. Read along with price data it's a useful data for traders who can interpret whether a trend is bullish or bearish. But often it could mislead those wet behind the ears.
2. Why is it important?
Higher the OI, deeper the market. High volumes along with high OI indicates greater hedger and trader participation on a stock futures or options counter. Conversely , high volumes and low OI means more speculative interest in a counter. Because OI is high a trader can gauge whether short-term trend in a counter is bullish or bearish.
3. How's that?
Rising OI accompanied by rising price is indicative of bullish trend. If OI remains flat after substantial price rise OI it indicates that market is forming a top. Similarly , rising OI but falling price indicates bearish trend. When OI does not rise much after a sharp fall in prices it indicates formation of a bottom and trend reversal.
4. Why can it mislead, especially during result season?
Markets discount. If a company is expected to perform poorly prior to results the stock will fall and open interest rises. If one looks at the options chain to gauge, the person will see a huge sale of call options and a relatively lower sale of put options. Higher call OI than put OI will probably make the person inclined to buy a call, thinking that the stock will rise post result. But actually the seller had sold or written more calls knowing downside chances are greater or any possible upside will be capped. So, the buyer will probably be on the wrong side. Therefore, it is important to take an informed decision and trade with strict stop losses in place. When writers feel a stock will rise, they sell puts and partly finance their own purchase of calls with premia received from buyers.
5. What more can happen?
Sometimes the buyer might see many calls being written and so, interpret that as meaning stock will face downside pressure and buy a put. But post poor results, if company gives positive guidance for quarters ahead, the stock could surge despite posting poor results and cause a loss to the put buyer as call writers start covering their shorts. That is open interest of calls begin to fall as price rises.
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