Alexander Elder - Trading For A Living
Open interest is the number of contracts held by buyers or owed by short sellers in a given market on a given day. It shows the number of existing contracts. Open interest equals either a total long or a total short position.
Stock market shares are traded for as long as a company stays in business as a separate unit. Futures and options traders, on the other hand, deal in contracts for a future delivery that expire at a set time.
A futures or options buyer who wants to accept delivery and a seller who wants to deliver have to wait until the first notice day. This waiting period ensures that the numbers of contracts that are long and short are always equal.
In any case, very few futures and options traders plan to deliver or to accept delivery. Most traders close out their positions before the first notice day.
Open interest rises or falls depending on whether new traders enter the market or old traders exit it. Open interest rises only when a new buyer and a new seller enter the market. Their trade creates a new contract. For example, if open interest in April COMEX gold is 8500 contracts, then 8500 contracts are held by bulls and 8500 contracts are owed by short sellers at the close of that day. If open interest rises to 8600, it means that the net of 100 new con*tracts have been bought and sold short.
Open interest falls when a trader who is long trades with someone who is short. When both of them close out their positions, open interest falls by one contract because one contract disappears. If a new bull buys from an old bull who is getting out of his long position, open interest remains unchanged: Open interest also does not change when a new bear sells to an old bear who needs to buy because he is closing out his short position.
Buyer ------ Seller ----- Open Interest
New buyer New seller Increases
New buyer Former buyer sells Unchanged
Former seller buys to cover New seller Unchanged
Former seller buys to cover Former buyer sells Decreases
Most futures and options exchanges release open interest data one day later than prices. Some exchanges provide phone numbers to call for prelimi*nary figures on open interest.
Technicians usually plot open interest as a line below price bars (Figure 34-1). Some chart services also plot average open interest for the past several years. Open interest gives important messages when it deviates from its seasonal norm. Open interest varies from season to season in many markets because of massive hedging by commercial interests at different stages in production cycles.
Open interest in currency futures tends to drop four times a year, at the time of a contract rollover. If open interest does not drop during a rollover, it shows a strong commitment among traders to the existing trend, which is likely to accelerate.
Crowd Psychology
It takes one bull and one bear to create a futures or options contract. A bull buys a contract if he is convinced that prices are going higher. A bear sells short a contract if he is convinced that prices are going lower. When the two trade, open interest rises by one contract. A single trade between one bull and one bear is unlikely to move the markets. But when thousands of traders make their trades, they propel or reverse market trends.
Open interest reflects the intensity of conflict between bulls and bears. It reflects the willingness of longs to maintain long positions and the willingness of shorts to maintain short positions. When bulls and bears do not expect the market to move in their favor, they close out their positions and open interest shrinks.
There are two people on opposite sides of every trade. One of them gets hurt when prices change. If prices rally, bears get hurt. If prices fall, bulls get hurt. As long as the losers hope, they hang on, and open interest does not change.
A rise in open interest shows that a crowd of confident bulls is facing down a crowd of equally confident bears. It points to a growing disagreement between the two camps. One group is sure to lose, but as long as potential losers keep pouring in, the trend will continue. These ideas have been clearly put forth in L. Dee Belveal's classic book, Charting Commodity Market Price Behavior.
Bulls and bears keep adding to their positions as long as they strongly disagree about the future course of prices. It takes conviction and disagreement to maintain a trend. Rising open interest shows that the supply of losers is growing and the current trend is likely to persist. If open interest increases during an uptrend, it shows that longs are buying while bears are shorting
because they believe that the market is too high. They are likely to run for cover when the uptrend puts a squeeze on them and their buying will pro*pel prices higher.
If open interest rises during a downtrend, it shows that shorts are aggressively selling while bottom-pickers are buying. Those bargain hunters are likely to bail out when falling prices hurt them, and their selling will push prices even lower. An increase in open interest gives a green light to the existing trend.
When a bull is convinced that prices are going higher and decides to buy, but a bear is afraid to sell short, that bull can buy only from another bull who bought earlier and now wants to get out. Their trade creates no new contract, and open interest stays unchanged. When open interest stays flat during a rally, it shows that the supply of losers has stopped growing.
When a bear is convinced that prices are going lower, he wants to sell short. If a bull is afraid to buy from him, that bear can only sell to another bear who shorted earlier and now wants to cover and leave. Their trade cre*ates no new contract, and open interest does not change. When open interest stays flat during a decline, it shows that the supply of bottom-pickers is not growing. Whenever open interest flattens out, it flashes a yellow lighta warning that the trend is aging and the best gains are probably behind.
Falling open interest shows that losers are bailing out while winners are taking profits. When their disagreement decreases, the trend is ripe for a reversal. Open interest falls when losers abandon hope and get out of the market without being replaced by new losers. When a bull decides to get out of his long position and a bear decides to cover his short position, the two may trade with one another. When they do, a contract disappears, and open interest shrinks by one contract. Falling open interest shows that winners are cashing in and losers are giving up hope. It flashes a red lightit signals the end of a trend.
Trading Rules
A 10 percent change in open interest deserves serious attention, while a 25 percent change often gives major trading messages. The meaning of rising, falling, or flat open interest depends on whether prices are rallying, falling, or flat at the time of change in open interest.
1. When open interest rises during a rally, it confirms the uptrend and gives a signal that it is safe to add to long positions. It shows that more
Tracking Commitments of Traders reports can help you find out whether new buying or selling is primarily done by small or large speculators or by hedgers (see Chapter 7).
Very few technical indicators use open interest. The Herrick Payoff Index is the best-known indicator that utilizes it.
short sellers are coming into the market. When they bail out, their short covering is likely to push the rally higher.
When open interest rises while prices fall, it shows that bottom-pick*
ers are active in the market. It is safe to sell short because these bar*
gain hunters are likely to push prices lower when they throw in the
towel.
When open interest rises while prices are in a trading range, it is a
bearish sign. Commercial hedgers are more likely to sell short than
speculators. A sharp increase in open interest while prices are flat
shows that savvy hedgers are probably shorting the market.
When open interest falls sharply while prices are in a trading range, it
identifies short covering by major commercial interests and gives a
buy signal. When commercials start covering shorts, they show that
they expect the market to rise.
When open interest falls during a rally, it shows that both winners and
losers are getting "cold feet." Longs are taking their profits, and shorts
are covering. Markets discount the future, and a trend that is accepted
by the majority is ready to reverse. If open interest falls during a rally,
sell and get ready to sell short.
When open interest falls during a decline, it shows that shorts are cov*
ering and buyers are taking their losses and bailing out. If open interest
falls during a slide, cover shorts and get ready to buy.
When open interest goes flat during a rally, it warns that the uptrend is
getting old and the best gains have already been made. This gives you
a signal to tighten stops on long positions and avoid new buying.
When open interest goes flat during a decline, it warns you that the
downtrend is mature and it is best to tighten stops on short positions.
Flat open interest in a trading range does not contribute any new infor*
mation.
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