In your interest

The accuracy with which an investor predicts the market direction can determine his success quotient. Big market players like hedge funds and banks use statistical and quantitative forecasting models to judge the near- or medium-term market sentiment, but these are too complicated for retail participants. While most investors rely on technical analysis, derivative market tools can also help judge the cash market direction. The most effective of these tools are open interest and futures prices. Considered simultaneously, they give an idea of the upcoming opportunities. Let us look at open interest.

Open interest is the total number of outstanding positions in the futures and options market at the end of the day. In other words, these are the unsettled contracts. Suppose A buys 20 futures contracts from B (futures seller) on May 3. The open interest for May 3 will be 20. On May 4, C buys 25 futures contracts from D (futures seller); the open interest for May 4 will rise to 45. On May 5, A squares off his position. If the counterparty is B or D, the open interest will fall to 25. But if the counterparty is a new entrant E, the open interest will be unchanged at 45. This is because though A has offset his position, E's position is still open.

Open interest is the most widely tracked indicator and is reported in real time. If it is positive, it implies an increase in open positions, and if it is negative, it means a fall in open positions. An increase in open interest along with a rise in price confirms near-term market bullishness, while a flat open interest along with an increase or decrease in price indicates a possible trend reversal. It is advisable to use average open interest along with the daily open interest and futures prices while predicting the cash market direction. Here are some open interest rules:

Rising prices and rising open interest: If prices are rising and open interest is moving above its average, it indicates buying interest. It means more participants with long positions are entering the market, indicating bullishness.

Rising prices and falling open interest: If prices are rising but open interest is going down at a rate higher than its average, it indicates bearishness. It signifies that prices are rising due to short covering, not due to any fundamental factors. A fall in open interest implies that the money is flowing out of the market.

Falling prices and rising open interest: If prices fall and open interest rises (more than its average), it shows bearishness. This is due to an increase in short positions that cause a price fall. The market will fall till investors continue to enter short positions.

Falling prices and falling open interest: If price falls along with the above-average fall in open interest, it shows a very short-term bearishness. Both go down as investors with long positions exit the market. Analysts describe this as a predecessor of a strengthening market as the price fall will stop when all disgruntled long position holders exit their positions. The falling open interest means no new aggressive short-sellers are entering the market.

Open interest numbers are available on the Webistes of the NSE and the BSE and investors must consider these along with prices and other technical analysis indicators for predicting market.