Open Interest as regulatory, strategy tool in commodity market
By Anil Mishra( MD & CEO, National Multi Commodity Exchange) :
In commodity derivatives market Open Interest is very important information which is used by the Regulators like Sebi as tool to regulate the derivatives market from being squeezed or manipulated. It is also a tool which smart market participants use to gauge the market behavior and analyze the future trend of the price and supply of the commodity.
First we shall discuss the Open Interest as strategy tool for the market participants. Open Interest is the total number of open futures contracts of a commodity for a particular month. For every contract there is a buyer for which there is matching seller, so the two market player’s diametrically opposite action combines to make one contract. The open interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number. 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.
Volume and Open Interest: Used in conjunction with open interest, volume represents the total number of contracts that have changed hands in a one trading session in the commodity futures market, greater the amount of trading during a market session, the higher the trading volume. The volume represents a measure of intensity or pressure behind a price trend, greater the volume, more we can expect the existing trend to continue. Volume precedes price, which means that the loss of either upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend.
So, if commodity price is increasing in an uptrend and open interest is also on the rise, it is interpreted as new money coming into the market (reflecting new buyers); this is considered bullish. Now, if the price action is rising and the open interest is on the decline, short sellers are covering their position which is resulting in market rally. Money is therefore leaving the marketplace; this is a bearish sign.
If commodity prices are in a downtrend and open interest is on the rise, it shows that new money is coming into the market, showing aggressive new short selling. This scenario will prove out a continuation of a downtrend and a bearish condition. Lastly, if the total open interest is falling off and prices are declining, the price decline is likely being caused by disgruntled long position holders being forced to liquidate their positions. This shows that the downtrend will end once all the sellers have sold their positions. The following chart therefore emerges:
Bullish : an increasing open interest in a rising market
Bearish : a declining open interest in a rising market
Bearish : an increasing open interest in a falling market
Bullish : a declining open interest in a falling market
If prices are rising and the volume and open interest are both up, the market is decidedly strong. If the prices are rising and the volume and open interest are both down, the market is weakening. If, however, prices are declining and the volume and open interest are up, the market is weak; when prices are declining and the volume and open interest are down, the market is gaining strength.
Open interest as regulatory tool
To prevent the market manipulation by big players, the regulator limits the position that any broker member or individual clients can hold. This is called position limit. There is total position limit and also within the total position limit separate limit is fixed for near month as well as far month. Near month position limit is more restrictive because manipulators could squeeze the market participants due to paucity of time in which contracts have to be fulfilled. Commodity exchanges monitor on line to ensure that position limit is not violated. In the near month if the open position is very high but within the regulatory limit the commodity exchanges initiate early delivery to smoothen the delivery process or invoke staggered delivery to ensure that buyers who have no intention to take delivery do not hold the open position during delivery period to squeeze the market, because due to staggered delivery when seller makes the delivery they would be forced to accept delivery. Hence such buyers normally roll over the position to next month.
In India Markets regulator Sebi puts restrictions on open position limits in futures trading for all commodities. The curb on open position limits in futures trading has been put at client level (individual traders) as well as member level (brokers). With regard to client, the regulator puts the overall position limit for a particular commodity which would be restricted to numerical position limits as mandated from time to time, as per circular issued by Securities and Exchange Board of India (Sebi). This limit is fixed based on the size of crop, import export data, consumption data, seasonality etc. For brokers, overall position limit for a commodity would be the numerical position limits as mandated from time to time or 15 per cent of market wide open interest, whichever is higher.
The near month position limit for a commodity is restricted to one-fourth of the client as well as trading member level overall position limit in that commodity.
In order to calculate overall position, all long and short positions of the client across all contracts on the underlying will be added up separately and higher of the two would be considered as overall open position. Further, to calculate near month open position, higher of long and short positions of the client in near month contracts would be considered. “Thus netting out near-month contract with off-setting positions in far months contracts shall not be permitted for the purpose of computation of near month position of any client.
Genuine hedgers can request the commodity exchange to give them additional hedge limits, which can be granted based on their actual production or consumption data which has to be substantiated with actual data and records.
From above facts it is clear that futures market is very transparent and better regulated. The market participants’ behavior is monitored by the Exchange and the Regulator through the online surveillance system and there is no discretion given to anybody. There is no special privilege given to big players.