Mentoring Session 4, Day 4: 01 June 2021

Open Interest & Trading Ideas

Hello Everyone,

We hope that you are enjoying the Mentoring program and learning new concepts that help you
become a better trader. During the last 3 days we have primarily been discussing Trading ideas
and data that you need to analyse to catch the Market Sentiment. We have discussed Opening
Trade ideas, Importance of World Markets and VIX and also seen how to prepare a plan for the
expiry session. We will keep revisiting these topics during upcoming days so you can use them
efficiently.
Today we will be discussing the most important link in the chain of Options trading i.e Open
Interest(OI). We have mentioned it earlier also that we consider OI as God for Options trading.
So put in the best of your efforts to learn how to decode the Open Interest. We shall be using
the help of some features of OI Pulse to decode this data.

So today’s document besides discussing Trading ideas shall focus on understanding OI

through following questions

What is Open Interest (OI)

What is the importance of OI
Who determines OI levels buyers or sellers?
How do we correlate change in OI with change in price?
What is OI Spurts and its relevance

So let’s begin

1. What is Open Interest (OI)?

Before we start discussing OI please answer a very basic question
“In Derivative trading what instrument is actually traded?”
We know that in equity trading we trade stocks, in debt trading we trade bonds , in forex
trading we trade currencies but in Derivative trading we trade Contracts.
In equity trading the underlying stocks are issued by the parent company but in
Derivative trading the underlying “Contracts” are generated as per the will of buyer and
seller. These contracts are traded between two parties, buyer and seller.There can be
any number of such contracts (subject to NSE rules) unlike stocks.
 So is there a way to know how many such contracts are there at the moment and
at what levels?
The answer is OPEN INTEREST. The numerical value of Open Interest denotes the
total number of outstanding contracts in the market at any given moment. We will
see how the price and number of derivative contracts are related to each other shortly.

Now kindly take note of the highlighted words to grasp the concept to the core

1. “total number of outstanding contracts”

2. “given moment”

If you are able to understand these two words you can proceed ahead.

So let us focus on “total number of outstanding contracts” first

Now to begin with there are two kinds of primary Derivatives- Futures and Options.OI
applies to both of them but OI analysis of Options yields relatively more information
about market sentiment. Initially we will try to understand concepts through Futures and
then apply it to Options.

We will oversimplify the real life scenario to understand the concept. Let us consider
BankNifty Futures.

Consider there are only two players in the Market, player A and player B.
Let us say at 9.15 AM at time of opening
Player A feels that Banknifty will go down whereas Player B feels it will go up. So they
enter a contract where Player A sells a contract and Player B buys that contract.
So at 9.15 AM there is only 1 contract present in the Market.
So “total number of outstanding contracts” at 9.15 is 1.

Now consider the situation at 9.20. The beliefs of both players become stronger. So
Player A sells 4 new contracts to player B. The situation would look like this

So at 9.20 AM there are 5 contracts present in the Market. 1 was originally transacted at
9.15 and 4 new contracts were transacted at 9.20

So “total number of outstanding contracts” at 9.20 are 5.

So from 9.15 to 9.20 there was an increase of 4 contracts

Now let us see what happened at 9.30 AM.

Suppose there is some bullishness in the environment, maybe some positive news has
suddenly popped up. Player A who had sold 5 contracts would start to worry. He would
like to cut down his losses and in order to do so he would have to reduce his outstanding
position. So he will approach the Buyer “B” and ask him to return one contract. Suppose
it happens this is how the situation will look like.
So at 9.25 Seller Buybacks one contract and tears it apart. So how many contracts do you see
remaining in the system?

So “total number of outstanding contracts” at 9.25 are 5-1=4.

So from 9.20 to 9.25 there was a decrease of 1 contract.

Now suppose the market moved up by 9.30. Player “B” would be in profit. Now he wants to book
some of his profit, for doing so he needs to sell his contracts. He can sell it to the original seller
or a new buyer as per his wish and price offered. Now suppose at 9.30 another player “C”
enters the market who is bullish about Bank Nifty and feels that it will go further up. He needs to
buy a contract in order to enter the market. At this moment it is likely that Seller “A” won't write
new contracts, so he will approach Player “B” the original buyer who wants to sell the contracts
to book some of the profit. A transaction will be done in this case.
It would look something like this
So what happened? One contract (Contract no 4, originally written @9.20) gets transferred to
new Player “C”

So “total number of outstanding contracts” at 9.30 are 4

So from 9.20 to 9.25 there was no change in the total number of outstanding contracts.
So the existing contracts exchanged hands but there was no change in the total number of
contracts.

Now what is Open Interest?

It is nothing but “total number of outstanding contracts” at any given time
(9.15/9.20/9.25/9.30).

So I guess you have an idea of what Open Interest is.

Since this was an oversimplified version of the real world, there are Multiple Players who buy
and sell simultaneously.

Just have a look at how OI changes from time to time in actual

2. What is the importance of OI ?

OI is the most reliable data that can be used to gauge the Market Sentiment and this is
the reason why it is so important. This data reveals what the majority of market
participants are doing at the moment. If we can align our trade with the dominant
sentiment of the market, it enhances the probability of successful trades. So if you want
to take successful trades confidently then having knowledge of OI is a must.
3. Who determines OI levels buyers or sellers?

It is a very serious aspect that one needs to ponder upon, who determines the Open
Interest buyer or the seller. Well the correct answer to this question is that both Buyers
and sellers together determine the total OI, since it is a contract involving both buyer
as well as seller. So though both determine the total outstanding OI but who out of the
two dominate the pricing of options? The answer to this question is that sellers
dominate the pricing aspect of options for the majority of time and this is the reason
that they dominate most of the time but certainly not every time.
It is an outcome of demand and supply. In derivative options sellers are suppliers
whereas option buyers create demand. There will be times when demand is high and
sometimes supply is higher. When the supply is higher the option prices tend to drop and
when demand is higher the prices tend to rise.

4. How do we correlate change in OI with change in price?

This aspect forms the core of the entire Open Interest analysis. The real useful
information that can be used for actual trading is how do we analyse change in OI with
respect to change in price of the contract.
In fact the change in price is actually an outcome of change in OI. It is an outcome of
demand and supply. In derivative trading options sellers are suppliers whereas option
buyers create demand. There will be times when demand is high and sometimes supply
is higher. When the supply is higher the option prices tend to drop and when demand is
higher the prices tend to rise.
Just consider the above graph. Suppose we are at an equilibrium at point 1. Now
suddenly the supply increases to point “2”, what do you think would happen to the price?
It would come down as the equilibrium is restored.
Similarly if the demand rises to “3” then the prices will increase to establish new
equilibrium.

Now in order to proceed further it is important that we understand following terms at a

functional level
Long Buildup
Short Buildup
Short Unwinding/Covering
Long Unwinding
 These four terms we shall understand through Options OI rather than Futures OI for
more clarity. The basic concept is the same for Options and Futures OI.

These four terms constitute the heart of this training session and shall be using them
extensively. Thus it is very important that you understand what these terms actually
mean. The following discussion would be a bit technical but very logical. Read this
section twice if you are not able to grasp the concept in one go.

These four terms actually refer to 4 different combinations of “Rise/Fall in Price” and
“Rise/Fall in OI”.
These four combinations can be
1. Rise in Price & Rise in OI
2. Rise in Price & Fall in OI
3. Fall in Price & Rise in OI
4. Fall in Price & Fall in OI
In order to understand them we will go back to our demand and supply graph
Shown above is a simple demand and supply graph, I have used it in the context of Option
contracts. Assume it to be a graph of CALL Option. Along X axis is Quantity of Contracts Open
i.e Open Interest and along Y axis is the Price.

Assume we are at point no 1 where the price is P1 and OI is O1. Now what will happen if there
is a sudden jump in supply of contracts. On the graph we will move from point no 1 to point no
2. Demand Supply equilibrium has been disturbed. Supply has gone to 2. Now in order to
restore the equilibrium demand will follow and the following will happen.
So New Demand curve is generated to accommodate new supply. If we analyse from the graph
what have been the outcomes?

i. Price has reduced

ii. Quantity (OI) has increased.

This is known as Short Built Up.

So what happened here , there was an oversupply of Call Option contracts and then buyers got
inclined to them but at a decreasing price.
When will this happen in a Call Option?. Only when the scenario is bearish i.e the Index is
moving or likely to go downwards.
What can we say if we are to analyse this in context of Put options. Put Option writers
would flood the market with new contracts when they are confident that index/underlying is
going to move upwards i.e scenario is Bullish. (A contrast but true).
So we would summarise short build-up in the following manner..

i. It is surely driven by Sellers or option writers. Buyers respond to them.

ii. It surely leads to lowering of prices of contracts.
iii. It means that Option Seller is confident that the price won’t cross this strike price. It is a
mixed signal and may have three interpretations
a. Index may decrease further. (Very High Short built up)
b. The underlying index may remain standstill. (Moderate Short built up)
c. Index may increase but not cross the strike price at which Short built up happens.(Low
Short Built up).

So as an option buyer I know that signals are mixed and should look for opportunities in
the opposite direction and not in their direction. This means if there is a high short built
up in Call option then being an option buyer I should concentrate on Put option.
Strikes with decreasing option prices but rising OI is a honey trap for buyers set by
sellers..STAY AWAY.

In a similar manner I will discuss the other three scenarios. I would use the following figure to
discuss them.
 Figure 3: Terminologies

LONG BUILT UP

Refer to figure 3.
Suppose initially the maker is at point no 1 and suddenly there is a jump in demand of contracts
(CALL contracts). The rise in jump happens from point no 1 to point. No 3 along the demand
curve. As a result supply would readjust but at an increasing price which is justified as new
buyers would be ready to pay more price than existing one and sellers would demand higher
price as they are going into a zone of discomfort.

So following are the outcomes

 i. Price of option contract increases
ii. Quantity (Open Interest) has increased.

This is LONG BUILT UP.

So what has happened here. The buyers have stormed in and broken the equilibrium. They are
enticing sellers to write more contracts by offering them more price. When do you think this
would happen? Only when the index moves in direction of Option buyer i.e In upward direction
for Call buyer and downward direction for a Put Buyer. Thus it may be both bearish or bullish
depending upon which side you want to be.

So it would summarise my understanding of long built-up in the following manner..

i. It is surely driven by Buyers or option buyers. Sellers respond to them.

ii. It surely leads to an increase in prices of contracts.

Now what can be the expectations in a Long built up?

I would start by saying that Long built up would happen at OTM strike price. It gives a strong
signal that price would move in this particular direction i.e towards OTM strike at which Long
Built up happens. We also have to respect the fact that so many sellers at the strike price with
long build up would provide a strong resistance for the price to cross that level.
As an intraday option buyer I’m only concerned with the rise in option premiums and that can
happen only if index moves in a particular direction and long built up provides that direction. So
in short Option Buyer is confident that

a. Index will not move against the direction.

b. It would easily move in the direction

So as an option buyer I should look for opportunities in the direction suggested by Long built up
and not in the opposite direction. This means if there is a high long built up in Call option then
being an option buyer I should concentrate on Call option.
So we see that short built at a strike indicates strongly that price won’t breach that level and
long built at OTM strike gives strong signal the price would move towards that particular strike
but may or may not breach it due to strong resistance offered by Option sellers. What if both
happen simultaneously. It is a strong signal for Option buyers. Consider following hypothetical
scenarios

Scene 1: Nifty Option Chain

ATM strike 9600
Strong Long Built Up @ OTM 9800 CE Option (Rise in OI+Price)
Strong Short Built Up @ OTM 9500 PE Option (Rise in OI and fall in price)
This indicates that chances are very high for the nifty to move towards 9800 from 9600. Totally
bullish market.

Scene 2: Nifty Option Chain

ATM strike 9600
Strong Long Built Up @ OTM 9400 PE Option (Rise in OI+Price)
Strong Short Built Up @ OTM 9700 CE Option (Rise in OI and fall in price)
This indicates that chances are very high for the nifty to move towards 9400 from 9600. Totally
bearish market.

SHORT COVERING & LONG UNWINDING

This is interesting. Refer to figure 3 again
Suppose initially the maker is at point no 1 and suddenly there is a pullout of contracts (CALL
contracts). This would now happen only in two ways.
Either the pullout would be led by buyers or the sellers. So OI would decrease in both cases.
Who caused it would be known only through price action.
If the sellers want to move out then to square off their position they need to buy back contracts
that they have already sold. So their buying action would lead to increase in demand and thus
prices. This would be Short Covering.
If the buyers want to move out then to square off their position they need to sell their existing
contracts. So their selling action would lead to increase in supply and thus decrease in prices.
This would be Long Unwinding.
So the identification goes as follows
Short Covering is Fall in OI accompanied with rise in price
Long Unwinding is Fall in OI accompanied with fall in price

In order to analyse it further we need to focus on the fact that OI is decreasing. But the big
question is WHY OI is decreasing and who is leading this closure and under what
circumstances. Think in following manner

● If a seller of contract is leading the contract closing/OI reduction then it may be because
of two reasons
○ To book his/her losses and save from further loss
○ To realise the profit

● Similarly If buyer of contract is leading the contract closing/OI reduction then it may be
because of two reasons
○ To book his/her losses and save from further loss
○ To realise the profit

So the conditions for both buyers and sellers are the same, it just happens during different
market conditions.

In fact all these conditions happen simultaneously. Let us try to understand it further.

Let us consider the following hypothetical situation.

Nifty spot price 9600 and we have a Long built up at 9800 CE option along with short built up at
9700 PE strike rate. So the signal is strong that the price would move towards 9800.
Now the price starts rising and reaches 9700. What would happen
We will still expect the Long Built up to grow stronger at 9800 CE.

Now the spot touches 9800. Here sellers start becoming nervous. Some may want to exit as if
the trend continues they would come in a loss making situation. These nervous sellers would
square off their position. However they may be sellers who expect that collective strong
resistance would lead to reversion of trend. So nervous sellers would exit and aggressive sellers
may enter. What nervous sellers would do is to close their contracts and what aggressive sellers
would do is to write new contracts. In this situation the price of option and OI doesn’t change
much.
Now assume price crosses 9800 and touches 9900 and trend establishes. What would happen?
Sellers would just want to exit by squaring off.Their action would create demand and thus further
rise in price of option. So OI would decrease and price would increase as sellers are covering
their position to book their losses.
Now assume the nifty touches 10000 and the trend slows down. Option buyers feel that
momentum is losing and call it a day. They would press the sell button and exit the market to
book their profits. They would have to sell their contacts and thus increase the supply. This
would lead to fall in prices along with fall in OI.

The cycle would look like this

i. Nifty @ 9600: Long Built up @ 9800 CE/Short built up @ 9700 PE: Strong bullish signal
ii. Nifty 9600—->9700: Long Built Up @ 9800 CE continues
iii. Nifty 9700—->9800: Nervous sellers-exiting position/Aggressive sellers -writing new
contracts: OI doesn’t change much
iv. Nifty 9800—->9900: Sellers start panicking: Would square off: OI falls.Short Covering.
Further rise in option premiums.
v. Nifty 9900—->10000: Buyers call it. Day. Book their profits: Would sell their existing
contracts. Oi decreases.Long unwinding.Option premium falls.

This is a hypothetical example..reality would be a bit distorted but things actually shape up in
this manner only.
I would again request you to read this section thoroughly to imbibe the understanding of these
four concepts at a functional level.

5. What is OI Spurts and its relevance

Now that you have a basic foundational understanding of Open Interest and its relationship with
change in price we must proceed with learning the practical aspect of using this information to
take actual trades. OI spurts is the answer to this query. OI spurts is a classification of strikes
according to the relationship between theri change in price and change in OI. In short it is a
table that reflects all the strikes that exhibit similar behaviour. It will classify all the strikes into 4
quadrants of Long Buildup, Short Buildup, Short Covering and Long Unwinding.
NSE also publishes this information but the user interface is not useful if you want to do quick
trading. OI Pulse’s OI Spurt feature simplifies the job for you.
It will look something like this

Here you can see the strikes falling in different quadrants at any given instant. Unlike the NSE
website you can see the data separately for Nifty and BankNifty.
Lets see what these quadrants are and what do the strikes appearing in them represent

1. Quadrant 1 (Q1): Rise in OI- Rise in Price

If you can recall this is something similar to Long Build up that we learnt while analysing
Futures OI. This holds true for options as well.
The strikes appearing under this quadrant (either CALL or PUTS) are those strikes
where the Option buyers are showing interest. If the buyers are active they would drive
the OI as well as the price upwards and this is what is the essence of this quadrant.
So if you are a buyer then you must focus on the strikes appearing in this quadrant.
However there is a very important catch in this. A strike simply appearing in the
quadrant does not qualify to be a prospective buying option. We have to assess its
“STRENGTH”. The strength has to be assessed on the basis of % change in LTP and %
 change in OI. If we see more than 50% change in LTP and more than 50% change in OI
then it is a strong signal that buyers are aggressively buying these options and thus they
may drive the prices further upwards.

Also if you see CALLs appearing in this quadrant with strength then it points that markets
may witness an upward movement. Similarly if PUTS appear in this quadrant with
strength then it points that markets may witness a downward movement.

So as a buyer of Options always focus on strikes appearing in Q1. If they are appearing
with more than 50 % change in LTP and OI then it is likely that the Premiums of these
strikes may rise further and thus they may be considered for buying provided all the
other connecting dots are also giving the same signal.

2. Quadrant 2 (Q2) : Rise in OI-Slide in Price

As learnt earlier Rise in OI along with slide in price points towards Short build up in
Futures. Similarly in options the concept is valid too.Strikes appearing in these quadrants
are those where the option writers are getting aggressive. They would like the option
premiums to slide further and expire worthless, so that they can capture the maximum
profit. However, as in Q1 not all the strikes convey strong signals. Only those strikes with
more than 50% rise in OI and more than 50% slide in price would actually give a strong
signal.
Thus if you are an Option writer then you need to focus on strikes appearing in this
quadrant provided that change in LTP and OI are more than 50%.

Also if you see CALLs appearing in this quadrant with strength then it points that markets
may witness either a downward movement or may just consolidate.. Similarly if PUTS
appear in this quadrant with strength then it points that markets may witness an upward
movement or may just consolidate.

3. Quadrant 3 (Q3) : Slide in OI-Rise in Price

This quadrant is very similar to the Short Covering phenomenon of Futures. If the strikes
appear in this quadrant then it means that the writers of these options are covering their
position thus we may witness a rise in premiums and provide a buying opportunity.
Needless to say the strength aspect that we saw in the other two quadrants also apply to
this quadrant.
If you are an options buyer then strikes appearing in these quadrants with strength may
be good buys for the option buyers. However it needs to be taken into consideration that
short covering rallies though violent are usually short lived. Thus perfect timing and
execution is very essential to play with strikes appearing in this quadrant.
 4. Quadrant 4 (Q4) :Slide in OI-Slide in Price
We advise retail traders to avoid strikes appearing in this quadrant. Usually deep OTM
options would appear in this quadrant. Such strikes are usually used by big players for
hedging their positions and may see sudden movements. Thus it is best to avoid these
strikes especially for buying.

We will be discussing some more practical aspects of OI spurts in coming sessions. The theory
part may bother you a bit initially but pay as much attention as you can as this will be the
foundation of your trading career.
 TRADING IDEAS

Now having discussed the theory part let us shift towards the practical aspect of trading. So we
will start with a discussion about the Trading plan for the day.

Opening Trades:
Today is a very special day wherein we should decide not to do any opening trades on
BankNifty because of following factors

1. BankNifty Index Management

2. New Margin Rules
3. Holiday in US on Previous day

It is very important that I again re emphasise that “No Trade is a great Trade” at times.

Bank NIfty Index Management:

Today since we are discussing after a gap of 2 trading sessions we need to emphasise on the
previous two sessions.
Previous 2 sessions saw Nifty rise to new ATH

While Banknifty did not perform on the same front. It did witness an up move but not strong one.
It is still away from the ATH.

It is very important to analyse reasons behind the same. There are two factors behind it
1. Reliance
2. Index Management

Reliance did exceptionally well and since it is the highest index weighted stock it pushed the
Nifty Index up.
On the other hand to keep Nifty 50 from rising too much the Big players used Bank Nifty as a
balancing instrument and kept its rise under check.
In such an environment where we know that BankNifty is being controlled to a great extent it
doesn't make sense to go aggressive on opening.

New Margin Rules

With effect from today new Margin Rules that come into picture. This may have any kind of
influence on Volumes that we may not predict. So it better makes sense to stay away from the
Opening trades.

World Markets
Yesterday it was a holiday in the US and markets were closed on account of Memorial Day. So
the data of US 30 Future will not be relevant for opening trade. INstead we must look at NIKKEI
and Hangseng instead. But till 9.00 AM one was positive while one was negative. So it doesn't
give any clue.

So because of all these factors we will not plan an Opening Trade. We will look for opportunities
on following setups
 1. Open High
2. 2 Candle Setup
3. ST/VWAP reversal

But before we do that we must analyse Price action to determine important Support and
Resistance Levels.

Bank Nifty Previous Day

On analysing the previous session we find that price after testing a low bounced back and Bulls
took control above 35304. So it will be a major support level for today.

Price remained above VWAP for the entire day and never came towards it. However toward the
end of day price reversed from its high and fell a bit with volumes so that suggests Profit
booking.

So it clearly states that though Bulls are in control at the moment but they are less confident
about taking the Market Higher.
In such a case Yesterday High of 35650 will be a Resistance Level and Bullish zone of 35304
would be a support zone before Yesterday low of 35061.

Bank Nifty Hourly Chart

As per hourly chart 35348 is a support zone and 35670 a resistance zone at the moment.

Open & High Trades

We have shared Open & HIgh Manual separately wherein the concept has been discussed in
greater detail. This morning we had OH appearing on both sides of the options chain. Since we
didn't get OH or OL on Futures we should have been moderate on position sizing.
Since the call side witnessed more number of OH strikes it made sense to look for opportunities
on the Call side initially.
Now what should have we done to take an OH trade? We should have waited for the
Momentum to come into picture.
Just notice the timing of Upward Momentum. It started around 9.22 and kindly look notice the
timings of OH being hit on CALL side

It was a clear Hit if we paid attention to the rules of OH concept.

OH on PE side and 2 Candle Trade

Since we had OH on Put side too we should have waited for Momentum to play on downside
and it did. Just look at it
9.57 Candle was a Golden opportunity to play on the PE side as we got 2 Bearish Candles
below VWAP and that too with Volume greater than 50 K , also OH on PE was there ..it was
screaming to be taken up. Just notice the downfall after that and see OH on PE matching time
It was a Golden Opportunity

Supertrend/VWAP Retracement
Now it was clear that Bears had entered the erstwhile Bullish territory so they will make every
attempt to defend their action. In such a situation whenever the price reached back to ST or
VWAP for first time it was a great opportunity to trade

We had 3 Retracement Opportunities.

Just see that we have marked Volumes of the 3 trades.
In Trade 3 the Price Moved to ST level with high Volume whereas in Trade 2 & 3 the movement
was without any volume. In such cases your position size should have been lower in Trade 1
as compared to trade 2 & 3 as it was more risky.
As take note of how our identified Support level played out.

2 candle Trade & Subsequent Retracement in afternoon

As you can observe that after being under the control of the Bulls price moved upwards and
crossed VWAP but aloof this was without Volume. In such cases the chance of Bears attacking
again is always there and that happened as we got 2 back to back red candles with volumes
greater than 50 K.
It was a perfect 2 candle setup and any entry in 3 candle would have been a good opportunity to
scalp had you trail your profits.
Subsequently there was one more Retracement trade at VWAP ST level as price approached it
without Volume.
For this trade kindly refer to following video as well for more clarity

https://www.youtube.com/watch?v=G6CBjgOJUw8
So overall you see that even without Opening Trades we had a lot of opportunities. We decoded
the market and played according to the music of the market.

So kindly go through the theoretical part and prepare for the next trading session on the basis of
Trading plans.

TIll then

Happy Trading!