How important is open interest?

A trader can take cues from open interest (OI), among others, to gauge potential trend in a stock. Read along with price data, it's a useful tool for traders who can interpret whether a trend is bullish or bearish. But oftentimes it could mislead those wet behind the ears. Read on.

1. What's OI?
The outstanding positions of traders.

2. Why is it important?
Higher the OI, deeper the market. High volumes along with high OI indicates greater hedger and trader participation. In a stock index 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.

Rising OI but not appreciable increase in price indicates formation of a price top. Similarly rising OI but falling price indicates bearish trend. But rising OI and not much downside in prices indicates formation of a bottom and potential reversal.

Reducing OI and rising price spells short covering. Reducing OI and falling price indicates long liquidation.

4. Still 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 rise.If one looks at the options chain to gauge, she 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 her 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 part finance their own purchase of calls with premia received from put buyers.

5. What more can happen?
Sometimes the buyer might see many calls be 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.