Trading Strategy – LIQUIDITY VOLUME AND OPEN INTEREST

LIQUIDITY VOLUME AND OPEN INTEREST

LIQUIDITY

Is Liquidity an issue with the derivatives market at all?

The Indian derivatives market is progressing in terms of volumes almost every month with daily volumes being in excess of Rs 3,000 crores on many days. Derivatives volumes exceed corresponding cash market volumes on most trading days. However, liquidity in individual counters is still not always easily found and investors need to be aware of this phenomenon.

Which stocks are more active?

While 41 stocks are traded at the NSE, one generally finds that the top 8 are liquid and the other 33 are not really liquid all the time.

Which options do you find actively traded?

In the case of options, we find that while the ATM options are traded in most counters, the liquidity in ITM and OTM options is very poor. Further, on most days, puts are less liquid than calls.

Which series is more active?

Most of the volumes are concentrated on the near month series. For example, currently, in April, you will find that the April series is most traded while the May and June series are hardly traded. Broadly speaking, 90% of the volumes are found in the near month series. The middle month series picks up in the last trading week towards expiry as traders roll over their positions.

What kind of bid-ask differences are found in illiquid items?

As an investor or trader, you may find in the less liquid products that you face very high bid-ask differences. For example, your computer might show 1.25 – 4.00. As a buyer, you will need to pay Rs 4 while as a seller you will get only Rs 1.25 for this product. Faced with such bid-ask differences, whatever strategies you might have formulated, you may not reach the desired profit levels in spite of your views being quite correct.

The following table provides you with volumes for 31st March 2003 along with volumes in the top 8 counters. You can observe that the top 8 counters constitute 81% of the market volumes.

TABLE 1

forex signals
VOLUMES

What is the significance of Volumes?

Futures Volumes are important if you are analyzing the strength of the movement of the scrip. If you find that the price has risen on a particular day and the Volume on that day are also significant then the rise in the price can be understood as a strong trend. On the other hand, if the price has risen, but Volumes have not been strong, then the rising trend might not be strong enough which might imply that the rise might be negated tomorrow.

What is a significant volume in this context?

The exact understanding of significant volume is based on the average volumes seen in that scrip during that relevant period. For example, if the average futures volume on Satyam has been Rs 150 crores and on that day a Volume of Rs 200 crores was seen with a rising price, one would believe that it is a strong Volume. In a relatively less active scrip, even a Volume of Rs 100 crores might be very significant.

I would suggest that you should consider the average Volumes of the last fortnight and any Volume level higher than 20% of the average should be considered significant. These are broad parameters and might require refinement from time to time.

Which Volume should you consider in this context?

Volume in this context should include Cash market volume, Futures Volume as well as Options Volume. In the case of Options, it might be appropriate to consider Call Option Volume minus Put Option Volume as the net Volume.

How do we interpret Option Volumes?

The general market practice is to assume that Call Writers are relatively skilled players who know how to read the market better and that Call Buyers are relatively simple investors. From this background, Call Writers are neutral to bearish while Put Writers are neutral to bullish. Thus Call Volumes would imply bearishness and vice versa.

This understanding might not be always correct and hence one needs to exercise judgment. For example, in a bullish market, the Call Writers might convert to Call Buyers. Further, many Writers might hedge themselves using Futures. A Call Writer might buy Futures if the market starts moving up substantially and create an upward hedge on the stock.

OPEN INTEREST

What is Open Interest?

Open Interest is an outstanding position in the Futures and Options segment. For example, if the Open Interest in Satyam Futures is Rs 200 crores, it implies that buyers and sellers who have transacted till this moment and have not yet squared up their positions have these many transactions open at the moment.

What does this imply?

The outstanding positions in the market should be read along with price trends and the volume trend. A rising price along with rising Volumes and a rising Open Interest will be a strong bull signal. Open Interest implies that fresh positions are being taken up, which might imply that fresh investors are entering the market or that existing players are increasing their position levels. On a rising trend, this indicates a strong upward move.

What do Options Open Interest positions imply?

High Call Option Open Interest would indicate bearishness while High Put Option Open Interest would indicate bullishness. It is a regular practice to net off the Call minus Put Open Interest numbers and analyze this trend. A rising trend (indicating more Calls Open Interest) would be indicative of impending bearishness on the scrip.

At what level are these analyzed?

Most traders analyze them at the scrip level. For example, you could total up the Satyam Calls Open Interest and Satyam Puts Open Interest and analyze the Net Open Interest levels. Some traders analyze it for the Index. Still, others total up all underlying scrips and the index and work out the Net Open Interest for the market as a whole.

I would, however, believe that it would work best at the scrip level and the index level separately.

Sometimes, Calls Volumes and Open Interests are so low that they may not merit any inference.

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