Predict long or short position by disinterest, interest & excess interest..

“But for every Buyer there is a Seller and for every Seller there is a Buyer, then how do you decide whether it is Long position or Short position?” This is one of the most common question that I have been hearing whenever I discuss open positions in the derivatives market. Let’s discuss it today!!

For the benefit of those who are relatively new to this segment, what are open positions or open interest? Analogously speaking, open interest in derivative market is similar to delivery in cash market. So, if I buy 100 shares of Reliance in cash market and square it off intraday there is no delivery only volume of 200 shares. While if I don’t square it off, I take delivery of the same 100 shares; so in that case the volume is 100 shares and delivery marked is 100 shares. Same applies to open interest. If I buy 1 lot of Reliance futures and cover it; that leads to volume of 2 lots, but if 1 buy it and don’t cover it, that would lead to volume of 1 lot and open interest of 1 unit. So, typically a buy and sell put together which is held on creates one unit of open interest at the end of the day.

So, how can one say that it is a long position or short position. Well, it’s confirmed by the underlying’s move. Finally, it boils down to demand – supply mechanism. For instance, in a stock if there are buyer for 100 shares and seller for 100 shares the price movement would be flat. But if there are buyers of 500 shares and seller of 100 shares, the price move would be upward and vice versa. It’s largely directional players who initiate the trade, which is supported by arbitragers or hedgers. That’s why it is said that there are three types of market participants; traders (speculators), arbitragers and hedgers. Price is impacted by traders; arbitragers and hedgers do not impact the price.

Delivery and open interest indicate the extent of conviction. For a price move with good volumes if not supported by good deliveries or open interest are believed to be weak move. It is perceived to be an intraday move rather than being a more sustained one. The conviction is missing, so it is a situation of DISINTEREST in the underlying’s move. It is important to understand that there so many algorithms which work intraday trades and by the end of the day, there is no committed money in to that move.

If the move in the underlying is with addition of open interest, that indicates INTEREST stepping in to the move. Participants are expecting the move to go on further, so they are ready to hold on their positions. If added to it are good delivery positions, that gives further strong confirmation of the move. There are instances when the price does not move and there is significant addition in open interest at times along with decent deliveries. This typically indicates accumulation or distribution. Wait for the trigger and prices react.

The extreme or EXCESS INTEREST situation is when the trade in one single direction, either long or short. This leads to creation of extreme long or short positions. The trade becomes a consensus one. Everybody is on the same side. During such scenarios you see; heavy open interest, news flows which confirm the trend, small news piece has a large price reaction, weak hands entering into system, volumes generally reduce and so does deliveries, rollover and arbitrage spreads get abnormal and Implied Volatility moves away from the normal zone.

We recently saw such a situation when markets came off incessantly during July. On 1^st July we were Nifty was at 11800 and on 1^st August it was at 10800. The stock futures open interest at the start of August series was the highest since last one year, negative news was at its peak, every small news piece saw huge price reactions, cash volumes were dipping, IVs started shooting up and every other trader on the street was negative on the market. In such a situation of excesses it becomes difficult for the market or stock to continue in the same direction. So, there is a shakeout, where weak hands are thrown out or stopped out. This is called Short Covering or Long unwinding. Such moves are extremely sharp and fast and very profitable, but it is very difficult to time them. The best way to play them is via option strategies.

The technique to gauge this situation is called PVOD (Price, Volume or Interest and Delivery) analysis. This can be understood well and researched effectively with the help some training.

Happy Trading.

Cheers!!!