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Wednesday, October 13, 2010

Open Interest

Concept Of Open interest:
Open interest (also known as open contracts or open commitments) refers to the total number of derivative contracts, like futures and options, that have not been settled in the immediately previous time period for a specific underlying security. A large open interest indicates more activity and liquidity for the contract.
For each buyer of a futures contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered ‘open’.
Use of Open Interest in Technical Analysis

Many technical analysts believe that a knowledge of open interest can prove useful toward the end of major market moves. For some option traders, open interest indicates the intensity of trading in a financial instrument. If open interest increases suddenly, it is likely that new information about the underlying security has been revealed, which may indicate a near-term rise in the underlying security’s volatility. However, neither an increase in volatility nor open interest necessarily indicate anything about the direction of future price movements. A leveling off of open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.
Technical analysts view increasing open interest as an indication that new money is flowing into the marketplace. From this assumption, one could conclude that the present trend will continue. Analogously, declining open interest implies that the market is liquidating, and suggests that the prevailing price trend is coming to an end.
However, according to the definition of open interest in this entry, a change in open interest indicates a difference in the number of buyers and sellers of a financial instrument. Like volatility, it has no directional component, it is just a tally of unsettled contracts.
Open interest is a concept all option traders need to understand. Although it is always one of the data fields on most option quote displays – along with bid price, ask price, volume and implied volatility – many traders ignore open interest. But while it may be less important than the option’s price, or even current volume, open interest provides useful information that should be considered when entering an option position.
So when you are looking at the total open interest of an option, there is no way of knowing whether the options were bought or sold – which is probably why many option traders ignore open interest altogether. However, you shouldn’t assume that the open interest figure provides no important information.
One way to use open interest is to look at it relative to the volume of contracts traded. When the volume exceeds the existing open interest on a given day, this suggests that trading in that option was exceptionally high that day. Open interest can help you determine whether there is unusually high or low volume for any particular option.
Benefits of  Open Interest
By monitoring the changes in the open interest figures at the end of each trading day, some conclusions about the day’s activity can be drawn.
Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend (up, down or sideways) will continue.
Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. A knowledge of open interest can prove useful toward the end of major market moves.
A leveling off of open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.
Open Interest Used for Confirming Indicator
An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.
The relationship between the prevailing price trend and open interest can be summarized by the following table:[3][4]
Price     Open Interest     Interpretation
Rising         Rising                       Market is Strong
Rising         Falling                       Market is Weakening
Falling        Rising                       Market is Weak
Falling        Falling                       Market is Strengthening
Courtesy  Copyrigh@wikipedia.org