A Study of Open Interest in Nifty futures

-Anilkumar Garag,
Associate Professor
MATS School of Business Belgaum

Executive Summary

This study is an attempt to find the build up of open interest in nifty futures. Open interest
signifies the amount of contracts not squared off in the futures market and therefore it
signifies the liquidity in the system.

The study is based on the empirical data collected for the period from June 2006 to July
2007. The Study explores the utility of far month contracts.

Theoretical Background

Open Interest: The total number of futures contracts or option contracts that have not yet
been exercised, expired, or fulfilled by delivery.

As open interest represents the number of contracts that have not yet been exercised,
expired, or fulfilled by delivery, we could easily say that the said future or option contract
is popular as there is a lot of open interest in the contract. Thus it suffices to say that open
interest is needed to have liquidity in the contract. As an when the contracts start trading
in the exchanges the open interest starts building up in these contracts. There is a lot of
commentary written on open interest in stock futures, index futures, stock options and
index options.

When open interest is the determining factor of number of people interested in the said
contracts, it is obvious that the market requires open interest to promote liquidity in the
market. An interesting feature of open interest is that the regulators, though they want
open interest to be there to promote liquidity, they put a cap on the amount of open
interest on all the contracts traded in the markets. A majority of literature tends to look at
open interest as a worrying factor whenever it reaches unmanageable levels. All the stock
exchanges in the world have a system of stopping the trading in futures and options
contracts whenever the open interest reaches 95% of the market wide limit.

In this kind of a scenario it can safely be assumed then, that open interest in futures and
options contracts is desirable to promote liquidity in the contracts but is also undesirable
when large numbers of contracts are outstanding.

Traders and technical analysts look at the open interest figures with great interest as these
statistics provide a sense of the depth of the market for a given contract. The daily change
in the open interest is used as a measure of liquidity in a particular contract. Some traders
and institutions will leave bought and sold contracts open, in different accounts, rather
than close them out, which tends to distort the absolute value of open interest reported.
Nevertheless it's the change that is relevant and that is the focus of for traders.
For traders, Open Interest is best used in conjunction with volume. Simply expressed, if
open interest increases as volume increases then we can say that the current trend, up or
down, is likely to continue. Conversely a decrease in volume with a decrease in open
interest may well indicate an end to the current trend.

It's also a way to gauge the strength of a move, more than just whether a market is
accumulating or dispersing contracts. If price records a big up day, which is not
accompanied with a similarly large volume day and an associated increase in open
interest, then we can say that the move probably doesn't have the strength to continue. In
fact, an up move associated with a decrease in open interest would suggest long
liquidation or shorts being stopped out and therefore contracts being closed out.

That being the utility of open interest in the market for traders, this study goes a bit
further and probes the rise and fall of open interest in nifty contracts traded on the
National Stock Exchange in India.

The futures market is used for hedging, speculation and arbitrage. The availability of
futures contracts augurs well for investors to hedge their portfolios and mitigate risk.
Higher open interest in the future and options contracts would suggest opportunities for
hedging the portfolios.

Research Problem
To study the build up of open interest in Nifty futures and to explore the liquidity
position of nifty futures in the market

Objectives of the study

1. To study the build up of open interest in Nifty futures
2. To relate the open interest to liquidity and depth of futures market in India
3. To examine the popularity and utility of far month futures in the Indian markets.

Method of Study

Data Collection

Historical data for nifty futures contracts of July 2006 to June 2007 were collected. Each
futures contract in the Indian markets starts of as a far month contract and then ends up
being the near months contract. Trading in futures contracts is allowed for one month,
two months and three months contracts. Thus each contract is alive for a period of three
months.

Contracts of July 2006 up to June 2007 were selected and historical open interest figures
of all the twelve contracts were collected for all the days that these contracts were traded.
Limitation of Study

1. The study is limited to the Nifty futures traded in the NSE for the period from
July 2006 to June 2007. this may not apply to other data from other exchanges.
But it would be able to give pointers on the trends in open interest in other
contracts in NSE.

2. The study is done at a time when there are still curbs in place on market
participation in derivatives markets by certain institutions and the derivatives
trades are settled by cash. The scenario may change with new participants coming
in and the trades getting settled by delivery.

Data consolidation

1. The nifty futures historical data was collected / downloaded from the NSE
website. The data was sifted through and the EOD open interest data was
arranged for all the contracts.
2. The last day of trading in the contract was set to zero and the open interest data
was arranged according to the days remaining for expiry.
3. The open interest for the contract on the first day and the last day of the contract
was collected and tabulated separately
4. The day the open interest crossed the last days open interest was also found out
and recorded separately.

Data Analysis

The open interest for all the contracts with respect to the days remaining for expiry
was tabulated and charted as shown in figure 1.
The chart shows that open interest in the contracts tends to pick up as and when the
contract tends to become the near month contract and there seems to be little or no
liquidity in these contracts when the contracts are far months contracts.

Since the open interest starts at zero and peaks at millions of underlying units it was
considered necessary to plot the same chart using a log scale as shown in figure 2.

F ig ur e 2 . Op en Int er est and D ays t o Exp ir y o n Lo g ar it hmic Scale

100,000,000

10,000,000
Jul-06
Aug-06
1,000,000
Sep-06
Oct -06
100,000
Nov-06
Dec-06
10,000
Jan-07
Feb-07
1,000
Mar-07
Apr-07
100
May-07
Jun-07
10

1
97 92 87 82 77 72 67 62 57 52 47 42 37 32 27 22 17 12 7 2

The chart shows clearly that open interest reaches 100,000 units when the contracts
become middle months contracts and reach a peak when they become near months
contracts.
A look at the open interest on the first day the contract is traded and the ast day the
contract is traded gives us the picture of how much the open interest tend to increase over
the life of the contract. The chart is shown in figure 3.

Figure 3. opening and closing OPEN INTEREST

70,000 14,000,000

60,000 12,000,000

50,000 10,000,000
Opening
40,000 8,000,000 Open
Interest
30,000 6,000,000 Closing
Open
20,000 4,000,000
Interest
10,000 2,000,000

- -
Jul- A S Oct-Nov- D Jan- F M Apr- M Jun-
06 ug- ep- 06 06 ec- 07 eb- ar- 07 ay- 07
06 06 06 07 07 07

The chart shows that the nifty-march-2006 futures started off with huge open interest as
compared to the other contracts in the sample. This could be attributed to the budget
expectations and the contract of the financial year-end.

The last chart is the most interesting chart amongst all. The open interest on the last day
of the contract is supposed to consist of those contracts that will be settled in cash (in
case of Indian derivatives market). We probed to find out the day on which this level of
open interest was crossed in all the contracts and the result is shown in figure 4.
 Figure 4. "Closing Open Interest" Day

45

40

35

30

25
Closing Open Int erest Day
20

15

10

0
Jul-06 Aug-06 Sep-06 Oct -06 Nov-06 Dec-06 Jan-07 Feb-07 Mar-07 Apr-07 May-07 Jun-07

On an average the open interest in the contracts when they are close to becoming the near
month contracts seems to be the number of contracts that will be open on the last day of
the settlement.

The following table shows day on which the open interest crossed the closing open
interest.

Table 1.

Closing Open
Month Interest Day
Jul-06 31
Aug-06 38
Sep-06 31
Oct-06 31
Nov-06 41
Dec-06 30
Jan-07 34
Feb-07 30
Mar-07 37
Apr-07 31
May-07 37
Jun-07 30
Average 33.42

Conclusions
From the above analysis it can safely be concluded that the open interest becomes
interesting only when the contracts are close to becoming near month contracts or on an
average they start becoming popular when 33 days are left for expiry. This raises a
question on whether the futures market have really evolved in India? This question
becomes pertinent since, open interest represents liquidity in the system and also the
popularity of the contract in the system.

Nifty is the most popularly traded futures contract in the entire derivatives market in
India. If this contract only starts becoming popular only when it tends to become the near
month contract, then it is pertinent to ask whether the Indian market needs to mature
further and to add more depth in the markets.

The statistics tend to show that Nifty futures market is shallow to the extent that there is
little or no volume in far month futures. This shallowness has resulted from lack of
awareness about the futures market amongst the retail investors and a majority of market
participants.

As the awareness of opportunities for hedging, speculation and arbitrage increases

amongst the market participants, especially the retail investors, there is a possibility of
increasing the depth of the markets and make the market more stable.

Bibiliography
1. Jian Yang & David A. Bessler & Hung-Gay Fung, 2004. "The informational role of open
interest in futures markets," Applied Economics Letters, Taylor and Francis Journals, vol.
11(9), pages 569-573, January.

2. Terry J. Watsham, Futures and Options in Risk Management, Thompson, 1998.

3. John C. Hull, Options, Futures, & other Derivatives, Pearson Education Asia, 2002.

4. http://www.asx.com.au/research/charting/library/open_interest.htm

5. http://nseindia.com/content/fo/fo_historicaldata.htm