Ask Mint | Everyone has heard of simple interest, but what is open interest?

Ask Mint | Everyone has heard of simple interest, but what is open interest?
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First Published: Sun, Jan 13 2008. 11 44 PM IST

Updated: Sun, Jan 13 2008. 11 44 PM IST
Stock markets are known for their random progress. Sometimes they move up, sometimes they move down and sometimes they even move sideways. But intelligent investors always keep looking for different cues to overcome the randomness. The futures and options market provides many indicators about market expectations. One such handy indicator is the open interest number in the futures and options market. But for our friend Johnny, the term open interest, far from being an indicator, is a source of confusion. The problem is that he does not even know what the term “open interest” means. Today, as usual, he is taking the help of Jinny.
Johnny: I have heard about simple interest, compound interest and even penal interest. But what is this open interest?
Jinny: Open interest has nothing to do with the types of interest rates you have heard about. People generally get confused between trading volume and open interest in the futures and options market. Open interest simply means all the outstanding futures or options contracts that have not yet been exercised or squared off, expired or fulfilled by delivery. Each transaction will be a part of trading volume but may not lead to increase or decrease of open interest.
Johnny: What? How so?
Jinny: Okay, let’s try to understand how it is so. Suppose you are buying a single call option from me. Your buying a single call stock option will result in a single contract of call option in which you acquire the right to purchase and I get obliged to sell the underlying stock. This transaction will create one trading volume and one open interest in the market. Both your right and my obligation form part of the same transaction and hence, a single call option contract would lead to single open interest in the market. You and I may square off our respective positions by entering into opposite contracts with someone else. For instance, you may square off your position by selling a call option and I may square off by purchasing a call option with a third party. These transactions will lead to an increase in trading volume. But will it change the position of the open interest in the market? No, because our squaring off with the third party merely brings someone else into our shoes. No separate rights and obligations are created. New parties will assume our existing rights and obligations under the contract. So the open interest of the market would continue to be the same. However, the number of options left open in the market would rise in case one new buyer enters into a derivative contract with one new seller. In that case, new rights and obligations come into existence.
Johnny: Then what leads to a fall in the open interest number?
Illustration : Jayachandran/ Mint
Jinny: The number of options left open would fall in case you settle your derivative contract either by cash or physical delivery at the expiry date. In either case, the derivative contract comes to an end leading to a decrease in open interest. Further, options contracts automatically come to an end at the expiry date if the party purchasing the option fails to exercise its right. There can be a fall in open interest before the expiry date in case parties square off by entering into an opposite contract with each other. If I had earlier sold you an option contract, I can square off by purchasing an option contract from you. Entering into opposite contracts will extinguish our mutual rights and obligations.
Johnny: Future trends? How can open interest tell us about that?
Jinny: Well, you can use the rise or fall in the open interest number as an indicator of the future expectations of the market. A rising open interest number indicates that the present trend is likely to continue. If the open interest number is stagnant, then it means that the market is in a wait-and-watch mode. If it starts declining, then the market is clearly in a trend reversal mood. In a rising market, continuous decline of open interest indicates an expectation of downward movement. Similarly, in a falling market, the decline of open interest indicates that the market expects an upward trend. But all said and done, trends in the futures and options market are all future expectations only, and like the performance of the Indian cricket team, expectations may go wrong anytime.
Johnny: Yes, Jinny, there is always a possibility of getting fooled by randomness.
What:Open interest means all the outstanding futures or options contracts that have not yet been exercised or squared off, expired or fulfilled by delivery.
How: The number of open interest in the market rises in case one new buyer enters into a derivative contract with one new seller.
When: If the number of open interest is rising, it indicates that the present market trend is likely to continue. If the number of open interest is declining, the market is likely to be in a trend reversal mood
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at realsimple@livemint.com
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First Published: Sun, Jan 13 2008. 11 44 PM IST