OPEN INTEREST AND MAX PAIN LEVELS AND HOW TO TRADE

THEM

What is Open interesOPEOPt?

Open interest (also known as open contracts or open commitments) refers to
the total number outstanding of derivative contracts that have not been
settled (offset by delivery). For each buyer of a futures contract there must be
a seller. From the time the buyer or seller opens the contract until the counter-
party closes it, that contract is considered 'open'.

How to calculate Open Interest

Each trade completed on the exchange has an impact upon the level of open
interest for that day. For example, if both parties to the trade are initiating a
new position ( one new buyer and one new seller), open interest will increase
by one contract. If both traders are closing an existing or old position ( one old
buyer and one old seller) open interest will decline by one contract. The third
and final possibility is one old trader passing off his position to a new trader
( one old buyer sells to one new buyer). In this case the open interest will not
change.
OPEN INTEREST AND MAX PAIN LEVELS AND HOW TO TRADE
THEM

INVESTOPEDIA EXPLAINS 'Open Interest'

1. A common misconception is that open interest is the same thing as volume
of options and futures trades. This is not correct, as demonstrated in the
following example:

Open
Time Trading Activity
Interest
Jan 1 A buys 1 option and B sells 1 option contract 1
C buys 5 option and D sells 5 option
Jan 2 6
contracts
A sells his 1 option and D buys 1 option
Jan 3 5
contract
E buys 5 options from C who sells 5 option
Jan 4 5
contract

 On January 1, A buys an option, which leaves an open interest and also

creates trading volume of 1.
 On January 2, C and D create trading volume of 5 and there are also five
more options left open.
 On January 3, A takes an offsetting position, open interest is reduced by 1
and trading volume is 1.
 On January 4, E simply replaces C and open interest does not change,
trading volume increases by 5.
OPEN INTEREST AND MAX PAIN LEVELS AND HOW TO TRADE
THEM
Benefits of Monitoring Open Interest
 By analyzing the changes in the open interest figures at the end of each
trading day, some conclusions about the day’s activity can be drawn.
 Increasing open interest means that new money is flowing into the
marketplace. The result will be that the present trend (up, down or
sideways) will continue.
 Declining open interest means that the market is liquidating and implies
that the prevailing price trend is coming to an end. A knowledge of open
interest can prove useful toward the end of major market moves.
 A leveling off of open interest following a sustained price advance is often
an early warning of the end to an up trending or bull market.

Open Interest - A Confirming Indicator

An increase in open interest along with an increase in price is said to confirm
an upward trend. Similarly, an increase in open interest along with a decrease
in price confirms a downward trend. An increase or decrease in prices while
open interest remains flat or declining may indicate a possible trend reversal.
The relationship between the prevailing price trend and open interest can be
summarized by the following table:

Price Open Interest Interpretation

Rising Rising Market is strong
OPEN INTEREST AND MAX PAIN LEVELS AND HOW TO TRADE
THEM
Rising Falling Market is weakening
Falling Rising Market is weak
Market is
Falling Falling
strengthening

What is Max Pain?

It is a theory which states on options expiry a stock will close at the point
where the most puts and calls combined expire worthless -- via dollar value.
The name is derived on the basis that the most “Pain” is felt to option holders
at a certain price or point.

INVESTOPEDIA EXPLAINS ' Max Pain '

DEFINITION of 'Max Pain ' the point at which options expire worthless. The
term, max pain, stems from the Maximum Pain theory, which states that most
traders who buy and hold options contracts until expiration will lose money.
According to the theory, this is due to the tendency for the price of a
underlying stock to gravitate towards its "maximum pain strike price" - the
price where the greatest number of options (in dollar value) will expire
worthless. 
OPEN INTEREST AND MAX PAIN LEVELS AND HOW TO TRADE
THEM

BREAKING DOWN 'Max Pain'

About 60% of options are traded out, 30% of options expire worthless and 10%
of options are exercised. Max pain is the point where option owners feel
"maximum pain," or will stand to lose the most money. Options sellers, on the
other hand, may stand to reap the most reward. The Maximum Pain theory is
controversial, and there is disagreement regarding if the tendency for the
underlying stock's price to gravitate to the maximum pain strike price is by
chance, or by some sort of market manipulation. 
OPEN INTEREST AND MAX PAIN LEVELS AND HOW TO TRADE
THEM

How to use 'Max Pain' in trading?

It's a based on the theory based on the fact that the option buyers are almost
retailers who typically always buy options whereas option writers/sellers are
professional/institutions who have a higher chance of winning and typically the
professional/institutions will have a higher chance of making profits. 

According to theory the underlying (NIFTY, for example) on the expiry day will
gravitate towards that point at which option buyers will feel the maximum
pain, basically a point where the maximum number of options, both calls and
puts value could become zero(worthless) on the expiry day. To calculate this
we need the open interest of both calls and puts for various strike prices of
NIFTY and use a correct formula to calculate the MaxPain point. 
OPEN INTEREST AND MAX PAIN LEVELS AND HOW TO TRADE
THEM
Thought the theory sounds like a conspiracy, if you look historically MaxPain
has proved to be a leading indicator predicting a fall/rise in the markets
provided you have considered only the relevant strike prices. 

Here… OIA tool will do the work for you. Just select the underlying which you
want to calculate the point of MaxPain and click the button analyze. Then go to
the tab “Max Pain”, its show you the chart of MaxPain as well the value of
point. 

Once you have calculated the value of MaxPain, then there are 3 ways in which
you can use it for trading assumes NIFTY is presently @ 7400 and MaxPain is
showing 7500. 

1) You can setup strategies assuming that NIFTY will towards 7500. 

2) You can use this for position management, which means that if NIFTY is
below the MaxPain, take large buy positions than short positions, because we
are generally expecting NIFTY to go up. Similarly if NIFTY is above the MaxPain,
take bigger short positions than long ones as you expect the market to come
lower towards the MaxPain. 

3) Keep tracking MaxPain and anytime there is a big move, either up or down,
use it as a buy or sell signal respectively. 

Source: Internet