Other Indications

So, instead of looking at price movements as the only significant movements on a chart, we can also look at volume and open interest and try to apply this additional information to interpret the mood of the market participants which is driving their actions. It is always useful to remember that the markets move, not in accord to some complex and mystical formula, but from what other traders and investors are doing. If we lose sight of that in our manipulation of the numbers, then we start to believe that, given a powerful enough computer, we can define the markets. That won’t help our trading.

For instance, think about the case where there’s a very high open interest figure and a market top. This is a bearish situation waiting to happen. If the price should come down quickly, it will catch a lot of traders in a long position and they will be rushing to close out while they are still in profit, or to cut their losses. Every one of the contracts that has been added during the uptrend represents one new long position and one new short position, and the longs will be rushing to mitigate their losses. The liquidation of all those contracts will take a time, and put a lot of bearish pressure on the commodity price. The effect can even snowball, causing more and more selling and downward pressure. You should always watch out when there is a very high open interest in a bull market, as the reversal can be rapid.

Having said that, when open interest has been steadily increasing in an uptrend you can get a warning signal of a change in trend if the level of interest declines. This can often happen in advance of any price indications. This would be a more controlled reversal, but nonetheless a change in trend. If you have noticed the warning, you will not be caught up in the rush to liquidate your contract.

Let’s say that instead of a defined up or down trend, the price has been trading sideways for a time. And open interest has been increasing, as traders decide that they ‘know’ which way the price is going to break out, and put in trades appropriately. Of course, only half of them are right and the rest of them may be caught out on the wrong side of the market.

You can look on the amount of open interest as pressure building up. Just imagine what will happen when the price does breakout. If it breaks out upwards, everybody on the short side of those contracts will be thinking of covering their position, and this flurry of activity will create a lot more upside pressure. If the breakout is downward, then the long participants may well want to sell to avoid losses, and that will push the price down rapidly. So either way, a large amount of open interest will accelerate the breakout.

More generally, any time there is a breakout into a new trend you will see some of the traders caught on the wrong side of the markets rushing to liquidate their holdings. The more there are, the more likely is a sudden response that causes the new trend to accelerate. In this way, commodities trading and open interest can cause different reactions than that with other financial securities, where for instance a constant number of stocks are held in the market. A drop in value can cause the longs to sell, but there were always the same number of longs, and consequently no particular build up of pressure.

Once a price pattern has completed you can view increasing open interest as confirmation that the pattern is valid. Curiously enough, sometimes you will also see the open interest dip as the pattern completes, and you shouldn’t let this distract you – it’s just the contracts on the wrong side of the market deciding to liquidate their positions.

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