Intro to Open Interest in the Futures Market

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Intro to Open Interest in the Futures Market

The total number of open contracts on an asset, known as open interest, is largely used in the futures market. All futures traders should understand open interest since it is often used to validate trends and trend reversals for futures and options contracts. In this section, we will look at what information open interest provides traders and how traders may utilize that knowledge to their advantage.

Key Takeaways

  • There is no set supply of futures contracts, as there is with existing shares of stock or bonds; a futures contract arises when a buyer and seller agree to it.
  • As a consequence, futures traders often use open interest in multiple contracts to evaluate market mood, interest, and liquidity.
  • Open interest may also be used by technical traders to identify trends and momentum possibilities, as well as to corroborate market timing on transactions.

Options Trading: Volume And Open Interest

What Open Interest Tells Us

Because a contract involves both a buyer and a seller, the two market participants join to form one contract. The open interest position published each day shows the day’s rise or reduction in the number of contracts, and it is represented as a positive or negative figure. A rise in open interest combined with a rise in price is believed to indicate an upward trend. Likewise, a rise in open interest combined with a fall in price shows a downward trend. A price rise or reduction while open interest stays level or declines may suggest a trend reversal.

Although it is sometimes overlooked as traders concentrate on bid price, ask price, volume, and implied volatility, open interest may assist options traders make better bets.

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8 Rules of Open Interest

Futures traders must learn and remember key open interest requirements. They have appeared in a variety of publications, and the following is an outstanding rendition of these guidelines given by chartist Martin Pring in his book, Martin Pring on Market Momentum:

  1. “It is an optimistic indicator if prices are rising and open interest is expanding at a quicker pace than its five-year seasonal average.” More players are joining the market, which means more purchasing, and any purchases are often aggressive in character.
  2. If open interest statistics flatten after a rising trend in both price and open interest, this might be a hint of an imminent peak.
  3. If the price drops suddenly, many weak longs will be forced to sell, hence high open interest near market peaks is a negative warning. Such circumstances may sometimes spark off a self-feeding, downward cycle.
  4. In a bull market, exceptionally high or record open interest is a warning flag. When a rising trend in open interest starts to reverse, a bear trend is likely to commence.
  5. If open interest grows during the consolidation, the breakout from a trading range will be significantly stronger. This is due to the fact that many traders will be caught on the wrong side of the market when the breakout occurs. These traders are compelled to exit their holdings when the price swings outside of the trading range. This concept may be extended to suggest that the bigger the increase in open interest during the consolidation, the greater the potential for the following move.
  6. Rising prices and a drop in open interest at a pace faster than the seasonal usual are both gloomy. This market position arises as a result of short covering, rather than fundamental demand, driving the upward price trend. Money is leaving the market under these conditions. As a result, after the short covering has run its course, prices will fall.
  7. If prices are falling and open interest is increasing faster than the seasonal average, this suggests that new short positions are being established. This process is bearish as long as it continues, but as the shorts begin to cover, it becomes bullish.
  8. A drop in both price and open interest implies that disappointed traders with long holdings are liquidating their bets. This trend is bearish as long as it continues. When open interest reaches a low level, the liquidation is complete, and prices may begin to rise again.”
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2002 chart of the COMEX Gold Continuous Pit Contract. Image by Sabrina Jiang © Investopedia2020

For example, in the above 2002 chart of the COMEX Gold Continuous Pit Contract, the price is increasing while open interest and volume are decreasing. As a general rule, this condition leads to a poor market.

If prices are rising while volume and open interest are increasing, the market is clearly robust. When prices rise but volume and open interest fall, the market is deteriorating. When prices are down and volume and open interest are increasing, the market is weak; when prices are declining and volume and open interest are decreasing, the market is strengthening.

The Bottom Line

Futures traders may use open interest to determine if the market is strengthening or weakening. Avoid making the usual error of ignoring this figure when assessing futures. The more you know as an investor, the less likely you are to be caught off guard in a lost investment. Remember, this is your money, so use it carefully.

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