Strength or Weakness?

In the same way as we did when looking at volume, we can set out some general rules for the strength or weakness of the market. If the open interest is up in a rising market, then the market is looking strong. Because the interest is up, new money is flowing into the market, which is a positive sign.

Take the same rising market, but with a declining open interest and it shows signs of weakness. This is because the rally in prices is fuelled mainly by people covering their short positions, in other words holders of losing short positions are liquidating them. We can tell this because money is leaving the market with the decline in open interest. Once everybody who wants to has covered their shorts, the uptrend caused by this action will weaken.

During a downtrend if the open interest is up that again suggests weakness in price, which will continue to show as a bearish trend. From a technical point of view what is happening is that new contracts are being opened by short sellers, and this market sympathy will continue to drive the price down.

Open interest reducing in a downtrend would show strength in the sense of the price slide slowing down. The interpretation of this is that the declining price is caused by traders liquidating their losing long positions, reducing the number of open contracts. As with the case above, where traders liquidated their shorts, we expect the market to turn when everybody who wants to has sold off.

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