Intro to futures and open interest

Before talking about open interest, let’s address the definition of futures contracts. A futures contract is an agreement to buy or sell something at a predetermined price at a specified time in the future. A key difference here is that “futures” means an obligation as opposed to a right.

An example of a futures

Let’s understand why someone would enter into such a contract. A great example of this was in 2007, when oil prices went from less than $60 a barrel to $140 a barrel. That increase, of course, dramatically increased the cost of gasoline. This increase really hit the airline industry.  One company - Southwest - had begun buying oil futures with a delivery date of about one year out and with a price that was just a little higher than the current price. That means when oil was selling for $60 a barrel in 2007, Southwest was buying oil futures for the same month in 2008 for about $65. Then, a year later, when oil prices were $140, Southwest was making money on their $65 oil futures contracts.

Now onto the main topic. Open Interest (OI) is a number that tells you how many futures (or Options) contracts are currently outstanding (open) in the market.  Remember that there are always two sides to a trade – a buyer and a seller. Let us say the seller sells 5 contracts to the buyer. The buyer is said to be long on the 5 contracts and the seller is said to be short on the same contract.  The open interest in this case is said to be 5.

In other words, wealth is transferred from buyers and sellers and no new wealth is created. For this reason, derivatives are often termed as a zero-sum game.

What does OI indicate then?

The change in Open interest does not really convey any directional view on markets. However it does give a sense of strength between bullish and bearish positions.

• • If the price and OI both increase, it means there are more trades on the long side.
• • If the price decreases and OI also decreases, longs are covering their position.
• • If the price decreases but OI increases, it means there are more trades on the short side.
• • If the price increases but OI decreases, shorts are covering their position.

Short covering

A short cover is when an investor sells an asset that he or she doesn't own. Essentially, short selling is a way to bet that the price of an asset will decline. The way to exit a short position is to buy back the borrowed asset in order to return them to the lender, which is known as short covering. Once the assets are returned, the transaction is closed.

Long covering

Unwind means offloading or selling a position. In trading parlance, long unwinding refers to selling of positions or assets owned for a longer period either to book profit or to exit it in anticipation of impending bearishness.

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