Nse options are European options, which means a buyer cant exercise the option until expiry. So according to this , an options contract created will be there till expiry. But call and put unwinding happens and OI reduces sometimes before expiry. How it happens in European model as the model says the exercise of option is not possible until expiry.
Also when a buyer exit the position, some one else is buying the contract again, so how OI reduces.
open interest is the total number of contracts in existence for derivatives markets. In stock market, total number (i.e. the total number of shares issued by a company) is usually fixed during a trading period. This requires some restrictions on the sell side - you either need to own the stocks to sell or borrow them for short sell. This ensures at no point in time, the total market-wide exposure - either for the buyers or the sellers - will exceed the outstanding shares of the company.
In derivatives markets, there are no such restrictions, and contracts comes into life (or disappears) as and when required. Imagine a market with only two participants, and A has 100 contracts long and B has 100 shorts. If B now wish to short another 10 and A agrees to buy, then open interestes increases to 110. If B, on the other hand, wants to reduce the short exposure by 10 (and A agrees to square off 10 out of her 100), then open interest reduces to 90. This applies to any derivatives markets, futures or options (american or european). Open interestes also get destroyed at exercise and at expiry.
Okay Thank you. I dont have any confusion about the scenario of increasing OI. Regarding decreasing OI, I am taking a point from your eg, pls correct me if I am wrong.
OI in our eg become 90 from 100 if the seller wish to exit the contract "provided the buyer A agrees to that".
So if seller is able to exit the contract only if the buyer agrees to do so, how can we say a call unwinding is a bullish signal. Option unwinding is considered in a seller point of view generally. A huge call unwinding means, market is bullish and sellers are exiting the contract. But in a bullish market, whether buyers will agree to exit the contract ?
If buyers are holding the contracts, whether call unwinding happen ?
Let's change our original scenario. Suppose instead of 2, there are 3 participants. A has 100 long, B has 100 shorts. Our new trader C has nothing as yet. Now suppose B tries to exit 10 contracts, but instead of A, C steps in. After the trade, A is 100 long, B is 09 shorts and C is 10 short. So total short (and long) is still 100. So there is no change in open interest, although there is a trade. The 10 shorts from B is just transfered to C. No contracts get destroyed - unlike our original case.
One of the fundamental pricinple of financial market is for every seller, there must be a buyer - otherwise there is no trade possible of course! Any buy (or sell) is not necessarily a bullish (or bearish) signal in any markets - options or otherwise. This is mostly a myth peddled in the media by so-called pundits. Increase (or reduction) in open interest means there is more (or less) money in the markets - that is it. For concluding anything else, you need to identify the activity of informed participants and the price action. Usually, people trading in large sizes (like hedge funds) are assumed to be more informed than people trading in smaller sizes (retails). So many tend to conclude bullishness or bearishness from large unwindings. Also, more people tend to follow momentum than mean reversion in their trading. So many conclude an increase in open interest along with an increase in price is a bullish signal. Best way to verify these "signals" is to look at past data and see for yourself. However, I must wan you, you may not find anything super interesting in the results.