Trendline Analysis and Open Interest

Discussion in 'Technical Analysis' started by MasterTrader, Mar 5, 2005.

  1. MasterTrader

    MasterTrader New Member

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    Trendline Analysis and Open Interest​


    Although Moving Averages offer an excellent means for determining the trend in the market, their lag and lack of precision makes it difficult to trade them in an optimal fashion. Trendline Analysis allows us to more effectively trade the market by clearly defining levels of support and resistance. This is particularly true when combined with an analysis of trends in the Open Interest. These analysis techniques may be applied to any time frame and are useful in developing a long-term "top down" form of market analysis. We'll go into greater detail on "top down" techniques in another article.

    Conventional wisdom holds that Trendline support is found at levels where buyers have consistently entered the market in greater numbers than sellers. Trendline resistance levels are those that have managed to consistently attract sellers over buyers. A Trendline is drawn by simply "connecting the dots". More specifically, connecting the lows below or highs above the market with a straight line and then extending that line into the future by continuing to the right hand margin of your chart. You will find a Trendline drawn off five high or low points much more resilient to penetration by the market than a Trendline drawn off just two points. Also, you will notice that a market trend tends to accelerate as it develops. For instance, you will be able to draw several Trendlines under a rising market with the slopes of each Trendline increasing as they move forward in time.

    Old support often turns into new resistance. This is largely because traders who got long at previous support levels will own their position under water if the support level is broken. Therefore, every time they have a chance to break even when the market pulls back to its old support level they will attempt to sell their longs. Thus, the weak longs are putting a cap on the subsequent rallies.

    Open Interest represents the total number of net open positions in the market. Open Interest is not the total number positions held overnight by all traders, just half of them. Increasing Open Interest is regarded as a sign of confidence in the trend as traders commit an increasing amount of capital to the market. Decreasing Open Interest is indicative of a lack of confidence in the current trend. Traders are liquidating their positions. Therefore, a rising market with decreasing Open Interest may actually be a bearish scenario. You can anticipate a decrease in Open Interest when a market retraces after a prolonged rally.

    Your optimal bullish scenario for establishing a long position would be to see a series of increasingly steeper Trendlines, drawn on three of more points, combined with rising open interest. Therefore, your chart shows you a confidently rising market with increasing momentum and capital commitment by traders.
     
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  2. sh50

    sh50 Active Member

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    Good show, my dear friend. Welcome to the forum. You have explained the finer points of trendlines vis-vis moving averages verywell. I thought the averages were the most sought after but trendlines with open interest seems to be a good combo. I am attaching a file oi.doc( from sify.com) that explains the basic mechanics.

    Now if you could be a bit more open with open interest. All the open interest data at nseindia.com. How exactly does one interpret that especially vis-a-vis derivatives. CNBC keeps talking about Open interest limits and their getting carried over and all that. What are abnormal and normal limits?

    It is strange that nobody has answered your posts but don't let that deter you. It happens to the best of us. I remember one excellent post of moneymanagement of our most popular member, creditviolet and if it can happen to him and that post it can happen to anybody. Even Jesus cured ten lepers in a day. Nobody thanked him. All part of life.

    One a personal note, when posts go unanswered, its good practice of ego management. We all know how the market goes against us and we have to bow to it. That;s what I say when it happens to me, "It's gone against you man and it hurts but all part of life". One cannot expect a response to all posts and I am now a post-hardened vetran but junior members with handsome contributions must be encouraged:-

    One cannot always expect people to respond
    The way they react to every movie of James Bond
    However,from encouraging new members one should not abscond
    Otherwise they may lose focus and start behaving like a scattered vagabond
    An encouraging response at this stage to them may prove as healthy as an almond

    I will get back to specifics after studying your posts thoroughlly. Keep it up and keep them coming. Remember that people in the film industry after a lifetime in the business do not know what will be a hit and what a flop. Likewise in this forum. Best to follow Bhagwat Gita's principle.
     
    Last edited: Mar 6, 2005
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  3. MasterTrader

    MasterTrader New Member

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    Thanks for your feedback sh50. I have no problems with unanswered posts. If anyone wants to learn anything one has to ask and get involved in a discussion. And in my opinion one of the best ways to learn is from more experienced members of any forum. I have learned a lot in this way.

    How to intepret Open Interest

    A contract has both a buyer and a seller, so the two market players combine 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.

    Three simple basic rules to intepret Open Interest

    1) An increase in open interest along with an increase in price is said to confirm an upward trend.

    2) Similarly, an increase in open interest along with a decrease in price confirms a downward trend.

    3) An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.

    Practical Open Interest rules when applied to stocks & commodities futures.

    Now, there are certain rules to open interest that must be understood and remembered. They have been written in many different publications, so here I have included a simplified and easy to understand version of these rules written by chartist Martin Pring's in his book "Martin Pring on Market Momentum":

    1) If prices are rising and open interest is increasing , this is a bullish sign. More participants are entering the market, involving additional buying and any purchases are generally aggressive in nature.

    2) If the open interest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an impending top.

    3) High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral.

    4) An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, expect a bear trend to get underway.

    5) A breakout from a trading range will be much stronger if open interest rises during the consolidation. This is because many traders will be caught on the wrong side of the market when the breakout finally takes place. When the price moves out of the trading range these traders are forced to abandon their positions. It is possible to take this rule one step further and say the greater the rise in open interest during the consolidation, the greater the potential for the subsequent move.

    6) Rising prices and a decline in open interest is bearish. This market condition develops because short covering and not fundamental demand is fueling the rising price trend. In these circumstances money is flowing out of the market. Consequently, when the short covering has run its course prices will decline.

    7) If prices are declining and the open interest rises this indicates that new short positions are being opened. As long as this process continues it is a bearish factor, but once the shorts begin to cover it turns bullish.

    8) A decline in both price and open interest indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.

    These rules apply to both - stocks & commodities futures.

    If anyone has any questions please post them!
     
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  4. sachin divase

    sachin divase Member

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    hi mastertrader(nice name) & sh50,

    Both of you have given valuable information in this thread.
    Like this please explian implied volatility and its impact on trend.
     
  5. bhavana

    bhavana Guest

    on which site i will come to know open interest positions?
     
  6. Neal

    Neal Member

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  7. MasterTrader

    MasterTrader New Member

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    Implied Volatility is nothing but the estimated volatility of a security's price and has nothing to do with trends. It is used mainly as a key variable in most option pricing models.

    If all other variables are equal, the security with the highest volatility will have the highest option prices.

    You can calculate implied volatility by using the implied volatility calculator at http://www.jerrymarlow.com/impvol/
     
  8. sh50

    sh50 Active Member

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    That's a nice and comprehensive post. Looks like a creditviolet in the making or a star is born.

    What you have spoken of is I think scrip specific when you speak of price and open interest in tandem. Supposing you were to anyalyse market data as in derivative denizens under bsplindia.com. Do you just compare them to their previous week to judge bullishness/bearishness. CNBC keeps talking of rollover at derivative settlement. What is a good rollover-80%

    Now that you mention implied volatility, are not the steps as follows:-

    1) First calculate historical volatility

    2) Then use that to calculate the option price

    3) If the Actual price is greater than calcualted price, calculate implied volatility.

    4)Use implied volatility to calculate current prices/ projected profitability.

    Now in that hoadley software they give profitability at current prices and expired date. The current prices do not make sense. Maybe you could give an example.

    Is it true that the hedging option strategies do not have relevance in India as it is an imperfect market?
     
  9. MasterTrader

    MasterTrader New Member

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    Thanks I like that but there are many more out there and many more in the making. Anybody participating in this forum is a star in their own right.

    Yes of course. When we talk of open interest (OI) it is always related to a single scrip or index or commodity.

    I normally plot OI on a chart and look at its slope and compare that to the current underlying price action.

    OI is not that effective in India for the simple reason that options here have an expiry of 1-2-3 months where as in the US you have 3-6-9 months.

    Most of the option trading in India is in the one month so really OI is not that helpful. I think that option trading in India is a joke. (one month is okay for futures, but for options it is simply too short a time).

    I personally use http://www.optionstation.com which does all the calculation for me.
     
  10. AMITBE

    AMITBE Well-Known Member

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    Hello sh50 and MasterTrader,
    I write my own experience:
    I have been reading and absorbing information from MasreTrader's postings here, and needless to say, he is doing a great job of helping us all.
    Whilst I feel grateful and benefited, I normally don't rush to respond for the reason that it takes a great deal of reading and research to really get into the detailing of the subjects MasterTrader (or anybody else) introduces us to.
    It would be so easy to put questions here and then wait for others to post responses, but that's hardly the way to gain knowledge.
    Strictly speaking then, making a posting here for me, is really a last resort in the search for answers. Once shown the direction, we are left with our own wits and willingness to seek further.
    The other day I had asked for and received help with sector wise listings at NSE, but finally had to manually type in more than a thousand entries off Dalal Street...ah..the Bhagwat Gita's principles again! ;-)
    It's with me, and if anyone feels interested please post here and I'll upload.
    This is a great forum and you are all good folks.
    Thanks
     
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