Use open interest data to gauge strength of the move: Shubham Agarwal

Suppose, a stock is experiencing a downmove, which has seen it slip 20-25 percent, without any serious relief en route. Now, after hitting a significant low, the stock reverses and moves up by 4-5 percent in a very short span of time. The move manages to take the stock to a price above the recent intermediate high.

This is when we are posed with the question whether this opposite move should be termed a Respite or a Reversal from the fall that pushed it down to almost 3/4th its value. The answer to this question lies in the answer to one more question. And that is ― What was the strength level of this recent upmove?

This strength can be termed the bias that one would have while trading a price move.

Apparently, futures trading activity gives a solid insight into consensus bias. All we need to do is look at the Open Interest (OI).

What is Open Interest?

Since Futures and Options (F&O) are derivatives, they are created out of stocks or indices and do not have a physical reference point of accountability. A buyer or a seller of an F&O contract creates a position, known as the Open Interest.

When a Futures contract is sold, it is a bearish move. Here, the trader would look to buy it back when the prices comes down. Conversely, a trader can buy a Futures contract, if he is bullish on it, and Sell it when the price rises.

The above explains how the rise in price vis-à-vis the fall in OI provides the trader with an indication of consensus bias.

Consider the following four scenarios.

Price Rise + Futures Open Interest Rise = Bullish Bias (Traders make a Buy Trade)

Price Fall + Futures Open Interest Rise = Bearish Bias (Traders make a Sell Trade)

But

Price Fall + Futures Open Interest Fall = Bulls Neutralising Bias (Buyer books profit)

OR

Price Rise + Futures Open Interest Fall = Bears Neutralising Bias (Seller books profit) a.k.a. Short Covering

From these four scenarios, two outcomes can happen with rise in price. These are: OI can rise or OI can fall.

To see if this is a Respite or a Reversal, the trader would need to make sure that the price rise is accompanied by a rise in OI. This will indicate that the upmove is not a short covering rally.

Here, it is worth noting that just one day’s observation will not be enough to arrive at a confident reading of the situation. A trend has to be ascertained before firmly arriving at the decision.

Data related to OI is easily available over the internet or in any Option Analytics application.

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