The Significance of Open Interest
This lesson will cover the following:
- What is open interest
- What do changes in open interest reflect
- Decision-making based on open interest
We have not discussed much about open interest so far in our guides which is why we will dedicate this article to it. In the options and futures markets, open interest represents the total number of contracts at the end of the current day which are not closed or delivered, thus the number of existing contracts. In the stock market, it reflects the number of buy orders submitted before the market opens.
It is a common misconception that volume and open interest are the same. Open interest changes when new traders enter the market or old ones leave it, because their trade creates a new contract or closes an old one. For example, if the open interest in July silver futures traded on the Comex division of the NYMEX is 5 000, then 5 000 contracts are held by bulls and 5000 by bears. If that number jumps to 5 500, it means that 500 new contracts have been bought and sold short.
Conversely, if open interest falls to 4 500, it means that bulls have closed 500 long positions, thus sold, while bears covered their shorts, thus bought. If a new bull enters the market and buys a contract from an old bull, then open interest remains the same because the number of contracts has not changed, they have just changed their owner. The same logic is in force for bears.
Overpowering the counterpart
Open interest illustrates the intensity of the battle between bulls and bears. The higher the open interest, the stronger the disagreement between the two counterparts is as both bulls and bears are willing to maintain their long and respectively short positions. When either one of them reach to a conclusion the market wont move in their desired direction, they will logically close out positions and open interest will decline.
As bulls and bears battle each other, one of the sides is bound to lose, but as long as there is a steady stream of potential losers coming in the market, the trend will continue. Rising open interest means that the number of losers is rising. In a bull trend, for example, rising open interest implies that bulls are buying, while shorts are selling since they are convinced the market has reached a high level and will soon reverse. However, as soon as losses become unbearable, they will cover their positions, thus buy, which will shoot the market even higher. However, if no new shorts enter the market, the trend is bound to exhaust soon enough. This means that rising open interest during a trend is favorable for its development and implies it will continue. The same logic is in force for bear trends.
If a bull wants to buy, but there is no bear who wants to sell, the only possible way for him to procure a contract is to buy from an old bull, who has previously bought lower and now sells higher. In this situation open interest remains the same as no new contract has been created, it is just switching owners. If open interest remains flat during a trend, it suggests that the number of losers has stopped increasing. The same logic applies for downtrends.
The last possible scenario is for open interest to decline. Declining open interest means that losers have given up hope and are exiting the market. As the conflict between bulls and bears eases, the trend is bound to reverse soon. While the losing participants are exiting the market and are not being replaced by new losers, activity is declining, which causes the winning party to cash profits and shortens the trends life. For example in a bull trend, as shorts exit the market (cover their positions and buy), and are not replaced by new shorts, winning bulls close their positions and sell, thus both exit the market and market activity stalls.
How to incorporate open interest in trading
Based on what we already said, we can summarize that both positive and negative changes in open interest, as well as the lack of change, give a sign about the current developments on the market, but also allow for predictions about future changes.
When open interest rises during a trend, it suggests that the inflow of losers is rising and the trend will be sustained, thus a with-trend position is in order.
When open interest flatlines during a market rally, it implies that the trend is in its exhaustion phase and the best long trades have already been done. This suggests to avoid entering new positions and tighten stops on already existing ones, bracing for the upcoming end of the trend. The same logic is in force for bear trends.
When open interest declines during a rally, it stands to show that the two parties are coming to an agreement and are exiting the market. In a bull trend, shorts cover their losses while bulls are locking in profits, generating a bearish signal. The opposite is in force for a bear trend. As a trend is accepted by the majority, its end is drawing near.
When open interest is gaining heavily while the market is in a trading range, this should be seen as a bearish sign since it implies that commercial hedgers are more likely to short than speculators.
When open interest declines during a trading range, it generates a bullish signal as it implies that commercial hedgers are covering their shorts in expectation for rising prices in the future.
Additional help required
In general, volume and open interest are regarded as “secondary” technical indicators used to confirm other signals on the charts. Thus, experienced traders dont base their decision-making solely on them, rather in conjunction with other signals to confirm their signals and to predict the extent of a market move. For example, a breakout accompanied by large volume suggest the move should be extensive, while a trend marking a new high on the base of low volume should raise attention.
Moreover, the higher the open interest, the more liquid the market is, which improves the execution of orders and reduces slippage. Thus, short-term traders which get in and out of trades more frequently, especially day traders, should choose markets with the highest open interest. The same counts for trading futures – you should choose the delivery months with the highest open interest.