Open Interest and Market Direction
Volume and Open Interest (OI) are widely used to assess the liquidity of an Option. High OI and / or Volume in Options usually means good liquidity, and consequently, once can expect decent Bid-Ask spreads. But very few traders tend to use OI as a tool to determine market (stock) direction. There are good reasons for this – you have to track OI for all the stocks you follow, and then for specific options at specific strike prices. Generally, this is not a practical approach.
But let’s say you were interested in a stock one particular morning. There’s pre-market chatter and you know that the stock is going to be hyper-active today. In this case, you’ve decided to focus your attention to this stock at least for the day. When a stock is in this state, it can give you multiple trading opportunities in one day itself – there’ll be an initial burst when the market opens, and then a cool-off period, and perhaps another big run or two late in the day. These moves can provide for an exciting day. So, how can you take advantage of this kind of a situation ?
This is a cutting-edge method (if I may say so myself 🙂 ) using Open Interest, that can provide you with high-probability entry or exit signals. Truth be told, I’ve not heard anyone else using this method as an indicator, so at this moment, I’m going to claim that this method is mine. And I’ve become more convinced over the years because it has worked quite well. What you’d want to do is note down the At-the-money Open Interest of the Calls and Puts before trading begins for 2 or 3 strikes. And then see what happens at 9:30 am ET.
There are four different combinations possible (assuming flat or sideways action is not among them) –
1) Stock is moving up, and Call Open Interest is increasing
This is Bullish. The increase in Open Interest (Call buyers coming in) is being confirmed by the momentum and price move to the upside. You can be more confident about taking a bullish position at this time.
2) Stock is moving up, but Call Open Interest is decreasing
This tells you the bullish momentum is probably going to run out soon. This is a leading indicator of a potential reversal in the stock. People are closing out their open Call positions. If you opened a Long Call in the previous case, you should be scaling out.
3) Stock is moving down, and Put Open Interest is increasing
Strong bearish sentiment and increasing. Good time to buy Long Puts and ride the wave down.
4) Stock is moving down but Put Open Interest is decreasing
The bearish sentiment is probably going to run out soon. This is again a leading indicator signaling a potential reversal move to the upside.
Whenever I’ve used Open Interest for determining market direction, it has resulted in a high-probability trade most of the time. So in my opinion, this definitely works. But the problem is it’s not practical to watch this for more than one stock at a time. So unless you’re focused on taking advantage of a big move in one stock for that day, this method is not scalable. The second problem is – it will only work on active stocks whose Options are also active. There are some stocks which will be very active in the stock market, but not quite so in the Options markets, even when there is fundamental news events around it. It won’t work there, because you need to be able to see some quick changes in numbers in the Open Interest column.
But if your goal is to make a killing on a day-trade on one active stock, by all means, knock yourself out..Let me know if you liked this method..and if you try it, would love to hear your experience.