Options data can provide many useful insights about the market. It is even possible to gauze market direction with predictable accuracy. How is it possible?

Here is how you can estimate market direction with options data. How can we predict market direction with Open Interest? However, before that, it is important to understand the basic concept.

Understanding Open Interest (OI)

Open Interest (OI) tells you how many options contracts are outstanding in the market.

Let’s understand this: whenever a seller sells 1 contract to a buyer. The buyer is said to belong on the contract and the seller is said to be short on the same contract.

The open interest, in this case, will be 1.

In the Option Chain, if the Nifty on 12 August 2021 Expiry at 16500 is 20,87657; it has two meanings:

• The number of Long positions at this strike price is: 20,87657
• The number of Short positions at this strike price: 20,87657

Importance of Open Interest (OI)

It is quite useful in understanding the liquidity of the market.

• Higher open interest means more is the liquidity
• Lower the open interest means lower liquidity

It is always suggested to choose a scrip with higher OI as it would be easier to enter or exit the trade.

How to Predict Market Direction with Open Interest (OI)?

Open Interest is useful data, but it would be the wrong approach to predict market direction with it. It should always be used in conjunction with volume data.

OI                   Volume        Interpretation 

Increase       Increase       Bullish

Decrease     Decrease     Probability of end of a bearish trend

Decrease     Increase       Bearish

Increase       Decrease     Bullish trend may end

Analysts typically use open interest to confirm the strength of a trend. Increasing open interest is typically a confirmation of the trend whereas decreasing open interest can be a signal that the trend is losing strength.

A simple interpretation could be:

• When Open Interest increases: money is moving into the contract
• When Open Interest goes down: money is moving out of the contract

Some other points to remember:

• Another thing to understand is abnormally high OI may be an indication of high leverage. A trader should stay cautious in this scenario.
• Very high OI at a particular strike price may act as a possible area of Support and Resistance.
• Look for strike levels where there is maximum OI at the Call Option side. It is usually difficult to break this range and acts as Resistance.
• Look for the strike levels where there is maximum OI at the Put Option side, it is a high probability the market may not break this range and may act as a possible Support zone.