Tips on Technicals - Open Interest
Tips on Technicals focuses on the basics of technical analysis. One of the most commonly used tools of professional traders is Open Interest. It is also one of the most misunderstood tools, usually avoided by the casual analyst.
Open Interest is simply the number of outstanding futures (or options) contracts for a particular commodity. In the futures markets, when one trader buys a futures contract, another trader necessarily sells one contract. In this so called "zero sum game," for every winner there is a loser. When the stock market crashed in 1987, many traders who bought stock index futures were bankrupted. However, these traders had to have bought their positions from somebody and those sellers collectively made a fortune. Only when a buyer later sells his position to a someone who had sold short does open interest decline.
Since it takes one bull and one bear to complete a trade and increase open interest it follows that there is a conflict of opinion as to whether the market is going to go higher or lower. The more bulls and bears in the market, the higher the open interest and the more conflict there is. When prices change, one of these two groups is going to get hurt. When prices go up, the bears suffer. When prices go down, the bulls suffer.
As the market goes up, the bears lose more and more money. Eventually, they give up and cover (buy back) their short positions. If they buy them back from new bears entering the market, open interest remains the same. These new bears are betting that the market has run out of power and will fall. If the old bears buy from old bulls who are taking profits, open interest falls. If new bulls do not enter the market now, demand pressure is decreased and the market will fall. This leads us to trading tactic number one: if the prices rise and open interest falls, the market is nearing a top and it is time to sell.
Figures 1 and 2
In example 1, September CBT Wheat was falling throughout the first half of 1993. Open interest was rising during that time which indicated that the bulls were forced to sell their positions and new bears were coming into the market to sell even more contracts. The bottom fishing new bulls did not provide enough demand for all of this supply so the market continued its trend down. In June, open interest fell by about 10% indicating that the bulls were starting to provide more pressure relative to the bears. A falling open interest after a trend generally indicates that it is time to close out open positions. By the end of the month, other technical indictors were signaling uncertainty and the market reversed course soon thereafter.
Example 2 shows the September LIFFE Bund contract 1993 summer rally. As prices rise, the old bulls start to take their profits. However, they sell to new bulls rather than to their old bear counterparts and this causes open interest to rise. Prices continue higher and old bears are forced to cover their short positions. By selling to the new bulls open interest is not reduced. This leads to trading tactic number two: if prices are rising and open interest is rising, it is safe to add to existing long positions. Note that open interest began to fall in August while prices continued to rise. This is bearish.
Open interest does not work equally well with all markets. The financial instruments, especially those that settle for cash, are affected by trading strategies at expiration that have nothing to do with bulls and bears. Example 3 shows the September 1993 S&P 500 contract. Note that there is a sharp downturn in open interest just prior to its quarterly expirations. Here speculators are buying and selling futures, options and the underlying commodity for arbitrage purposes. This does not mean that open interest does not work but rather that the analysis needs to be adapted somewhat.
Figures 3 and 4
Markets with higher open interest respond best to technical analysis. December NYCE Cotton, in example 4, shows how large price swings can be caused by low liquidity and no underlying bullish or bearish support. Cotton prices jumped in early July but open interest, the numbers of traders who were involved, did not rise. In fact, open interest drifted lower. Prices fell just as quickly as they rose by the end of the month. Traders looking at open interest saw that the rally was not based on true supply and demand and were not fooled by the short term volatility.
Here are the rules for trading with open interest:
| PRICE |
OPEN INTEREST |
CONDITION |
COMMENT |
| rising |
rising |
bullish |
new bulls buying, old bears covering their shorts |
| falling |
rising |
bearish |
new bears selling, old bulls taking their losses |
| flat |
rising |
bearish |
in non-financial commodities, hedgers (producers of the commodity) are more likely to short the market to lock in delivery prices |
| flat |
falling |
bullish |
here, hedgers are covering their shorts |
| rising |
falling |
bearish |
no new bulls are coming in to buy from the profit takers |
| falling |
falling |
bullish |
bulls have given up by selling to the short-covering bears |
| rising or falling |
flat |
uncertain |
no change in open interest means that traders are looking for news on market direction and positions should be closed |
