Dear Traders,
Open Interest, MaxPain and Put Call ratio are some of the most misunderstood topics amongst beginner/amateur traders; below is our attempt to simplify these concepts for you:
1. What do you mean by Open Interest (OI) in futures and options?
Futures and options are contracts and similar to any other contract it is a contract between a buyer and a seller. Buyer is bullish (expecting the market to go up) and seller is bearish (expecting it to go down). Only when there is trade between a buyer and seller, a contract opens and all such open contracts are together called as open interest. So if I have bought 1 lot of Nifty expecting it to go up and you have sold 1 lot expecting it to go down, that makes it 1 open contract and hence the open interest of 1.
Typically every derivative contract will have its own OI, Nifty August futures will have its own OI and September futures will have its own. Similarly, OI will be different for calls and puts of various strikes.
2. What would you infer if someone said “Nifty futures went down with a huge addition of OI?”
OI will go up when more people start participating or existing people start adding positions. According to the OI theory, typically when a market is going in a particular direction and there is a huge addition in OI, this means there is more conviction in the move.
So if the market is falling and there is a huge addition in OI, this would mean that the existing short positions which are making profits are adding more and hence the fall could be bigger. But understand that this is only theory and may or may not work like this in reality.
3. What would you infer if someone said “OI on Nifty 5600 calls went up significantly?”
While trading options, the money required to buy options is much lesser than what is required to write (sell first). So typically the people who write options are people having access to higher capital and hence the logic is that they are more proficient traders.
I guess it is important to also understand why retail traders typically buy options and institutions sell them?
Retail traders are always looking at buying options because technically you have chances of making unlimited profits with investments of small premiums, very similar to how lottery tickets work. What a retail trader forgets to look at is the fact that the odds of winning are much lower than when you are writing options. Yes when you write/sell options the profit is limited and is probably just a fraction of the margin that is blocked for writing, but the odds of winning go up significantly.
Assume that Nifty is at 5550 and A buys the 5500 call at Rs. 100 as he is bullish and B who is bearish and expects the Nifty to be lower sells it at Rs. 100.
Since A is buying Rs. 5000 (50 x 100) is debited from his trading account and since B is writing options (around Rs 25000 is blocked as margin). A can make unlimited profits from his Rs 5000, but B can make a maximum of Rs 5000 from the Rs 25000 invested. But check out the odds and see which side you want to be on.
For A to win at Expiry: Only if Nifty is over 5600 (5500 + 100 invested into the call option)
For B to win at Expiry: Nifty stays where it is, Nifty goes below 5500 and Nifty goes up but stays below
Open Interest, MaxPain and Put Call ratio are some of the most misunderstood topics amongst beginner/amateur traders; below is our attempt to simplify these concepts for you:
1. What do you mean by Open Interest (OI) in futures and options?
Futures and options are contracts and similar to any other contract it is a contract between a buyer and a seller. Buyer is bullish (expecting the market to go up) and seller is bearish (expecting it to go down). Only when there is trade between a buyer and seller, a contract opens and all such open contracts are together called as open interest. So if I have bought 1 lot of Nifty expecting it to go up and you have sold 1 lot expecting it to go down, that makes it 1 open contract and hence the open interest of 1.
Typically every derivative contract will have its own OI, Nifty August futures will have its own OI and September futures will have its own. Similarly, OI will be different for calls and puts of various strikes.
2. What would you infer if someone said “Nifty futures went down with a huge addition of OI?”
OI will go up when more people start participating or existing people start adding positions. According to the OI theory, typically when a market is going in a particular direction and there is a huge addition in OI, this means there is more conviction in the move.
So if the market is falling and there is a huge addition in OI, this would mean that the existing short positions which are making profits are adding more and hence the fall could be bigger. But understand that this is only theory and may or may not work like this in reality.
3. What would you infer if someone said “OI on Nifty 5600 calls went up significantly?”
While trading options, the money required to buy options is much lesser than what is required to write (sell first). So typically the people who write options are people having access to higher capital and hence the logic is that they are more proficient traders.
I guess it is important to also understand why retail traders typically buy options and institutions sell them?
Retail traders are always looking at buying options because technically you have chances of making unlimited profits with investments of small premiums, very similar to how lottery tickets work. What a retail trader forgets to look at is the fact that the odds of winning are much lower than when you are writing options. Yes when you write/sell options the profit is limited and is probably just a fraction of the margin that is blocked for writing, but the odds of winning go up significantly.
Assume that Nifty is at 5550 and A buys the 5500 call at Rs. 100 as he is bullish and B who is bearish and expects the Nifty to be lower sells it at Rs. 100.
Since A is buying Rs. 5000 (50 x 100) is debited from his trading account and since B is writing options (around Rs 25000 is blocked as margin). A can make unlimited profits from his Rs 5000, but B can make a maximum of Rs 5000 from the Rs 25000 invested. But check out the odds and see which side you want to be on.
For A to win at Expiry: Only if Nifty is over 5600 (5500 + 100 invested into the call option)
For B to win at Expiry: Nifty stays where it is, Nifty goes below 5500 and Nifty goes up but stays below