How to interpret futures price and open interest

By Sahaj Agrawal, AVP- Derivatives, Kotak Securities

Every investment that we make- as players or as investors, is made on solid reasoning and research. The research in turn is based on understanding market movements, trends and indicators that allow us to understand what is expected to happen in the future.

Thus we come to the most important part of derivative investing – understanding derivative indicators!

In stock market investing, we make decisions about what position to take on which stock through careful analysis. Market participants have been doing this through two different yet basic approaches: fundamental analysis and technical analysis. While Fundamental analysis delves into the nitty-gritty of a Company’s financial performance as opposed to only its price movements and answering where to invest and why, Technical analysis believes in a stock’s performance history lends itself to expectations of how it will behave in the future. With the derivatives market activity increasing by the day, the opportunities in the segment can be lucrative if traded with the right parameters and insights.

As the name suggests, Indicators help in identifying possible changes that may optimize or change current trends in any particular financial time series and selected parameters. In Derivative markets, Indicators play an important role in identifying market sentiment leading to possible movement of price.

Both Futures and Options Contracts have different sets of indicators that are carefully tracked. A common parameter across derivative contracts is the Open Interest or OI. Translated OI would mean the total number of Contracts - both Options and/or Futures that are still open i.e that have not been closed in a particular trading day. Thus, Open Interest is the total number of outstanding Contracts that are held by participants at the end of every day. While prevalent in both markets, it is often used to confirm price movement trends and/or reversals in such Contracts. Open Interest also allows for the tracking of buyers and sellers in the Contracts Markets, ensuring one Buyer for every Seller. The Open Interest position calculated every day is either positive or negative versus the previous day. More positions would mean more cash inflows into the market, while a decline in positions would imply liquidity and that the prevalent price movement has reached its end and it’s a time for  possible reversal.

Relationship between Price and Open interest

Price	OI	Position
UP	UP	Long
Down	UP	Short
UP	Down	Short Covering
Down	Down	Long Unwinding

 

 

Futures analysts track price movements in premiums and discounts of Contracts in relation to cash markets. Most of this evaluation is based on the relationship between Futures Contracts and their corresponding spot prices also known as Cost-of-Carry. It primarily indicates the sentiment of the participants on the basis of the premium or discount.

Options Contracts tend to consider two major indicators to invest. These are put-call ratio (PCR) and implied volatility (IV).

Put Call Ratio as the name suggests is a ratio of the total number of put options by the total number of call options. There are many variants of the same depending on the data used to calculate it. Primarily there are two types – PCR OI and PCR Volume.

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Within PCR-OI, there could be PCR-OI for the Market, PCR-OI for a particular underlying or PCR-OI for an entire series. These would indicate either strong support or resistance depending on the open interest build-up. The second variant uses traded volume in puts and calls as input parameters. Higher activity suggests bias of the market towards any particular direction. If the number of puts is higher than the number of calls, it could indicate a bearish market while the opposite would indicate a bullish market. Normally, in cases of extremely high ratios, it would indicate that the market is either ready to bounce back from a period of lows or there is correction expected.
The last but not the least of indicators would be Implied Volatility or IV. Implied volatility is a key indicator in the options segment. The IV’s indicate the volatility that the market participants are expecting in the underlying, index or stocks, in the near term.

IV’s have a direct impact on the option pricing and hence knowledge of the same will help in taking right trading decisions. Buying options when the IV’s are low and writing when the IV’s are on the higher side could result in increased probability of a favourable trade.  

These are some of the measures that help analysts anticipate the market movement and take precautions or spot possible opportunities and take advantages accordingly. These indicators are used in several permutations and combinations to effectively track, measure and successfully manoeuvre the rocky roads of the Indian Derivative Markets. So hop on board and let them indicate the way...to profit!

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