Using Open Interest To Gauge Market Sentiments In FuturesTrading 17 Oct 2012

Using Open Interest To Gauge Market Sentiments In FuturesTrading

Market sentiment is the feeling or the tone of the crowd, also known as market psychology. It is a combination of all views, ideas and opinions and activities of participants in the market.

This is reflected by price movement of the securities. Rising prices will indicate a bullish market sentiment while falling prices will indicate a bearish market sentiment.

Market sentiment is probably one of the most important factors that drives the prices of the futures market yet it is an aspect of trading overlooked by traders.

One of the ways to gauge market sentiments is through open interest.

Open Interest

Open interest is the total number of contracts entered but not yet offset by a transaction or delivery for the day. In other words, these contracts are still outstanding or in open positions. Open interest is reduced when contracts are offset off their positions.

Open interest increases when there is money flowing into the market. It means that speculators are putting their confidence in the current market direction.

With this increase in open interest, it generally supports the current market trend and points to a continuation of the trend unless the sentiment changes due to new information.

On the other hand, open interest decreases when speculators want to pull out from the market. Thus, it implies that the current price trend is lacking in power as there is not enough significant money that has entered the market.

It is an indication that the trend will be coming to an end and a trend reversal may occur.

The graph above shows as open interest rises, the trend continues to be strong, in this case an upward trend.

Therefore as a rule of a thumb, rising open interest indicates a continuation of current price movements regardless it’s an upward and downtrend. Declining open interest gives a signal that trend is weakening and a trend reversal may occur.

When trading futures, you should make use of open interest to gauge market sentiments and to confirm the strength or weakness of current trade in line with your trade.

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Interpreting Volume and Open Interest for the Futures Market

VOLUIME & OPEN INTEREST

The Beginning and End of the Day

It should be noted that volume is expected to be clustered on both ends of the trading day. In the morning, orders are entered into the market early as traders are reacting to overnight news and events as well as the previous day's data that is calculated and analyzed after the close. The end of the day is active due to traders juggling for position based on today's price movements. Closing price is typically the most dependable value of the day.

Chart Patterns

The volume of intraday trading displays typical chart patterns, such as a rounded bottom formation demonstrating lowest volume in the late morning when the traders take their breaks. The patterns of individual issues, however, may differ from these patterns. European currencies, for example, show more sustained high volume through late morning due to the prevalence of European traders in the markets at that time. To account for such patterns, compare today's 30-minute volume for a specific time period with the previous average volume for the same period.

Interpreting Volume using Open Interest

Open interest is the measurement of those participants in the futures market with outstanding trades. Open interest is the net value of all open positions in one market or contract and portrays the depth of volume that is possible in that market. A market with a low number of contracts per day but also a large open interest tells the trader that there are many participants who will enter the market only when the price is right.

New interest in a market brings new buyers or sellers, which increases the value of open interest. When the open interest increases with a correspondingly quick rise in prices, more traders are likely entering long positions. That said, for every new buyer of a futures contract there must be a new seller, but the seller is likely to be looking to hold a position for a few hours or days, hoping to profit from the ups and downs of price movement. The open interest is attributed to the position trader, but such a trader is willing to hold the long position for a much longer period of time. If the prices keep rising, the longs will have the ability to hold their position for a greater period of time while the shorts are more likely to be forced out of their positions.

Some rules of thumb for interpreting changes in volume and open interest in futures market are as follows:

• A rising volume and a rising open interest are confirmation of a trend.
• A rising volume and a falling open interest suggest position liquidation.
• A falling volume and a rising open interest point to a period of slow accumulation.
• A falling volume and a falling open interest depict a congestion phase

Volume and open interest can be used in a practical sense to guide one's trades as follows

• Open interest increases during a period of an exhibited trend.
• During the accumulation phase, volume may decline while open interest builds, but volume occasionally spikes.
• Rising prices and a declining volume or open interest indicate a pending change of direction.

These rules, however, have exceptions, especially on days or at times when volume is expected to differ from the "norm". For example, volume is usually lighter on the first day of the week, on the day before a holiday, and during the entire summer period. Also volume may actually be heavier on Fridays and Mondays during a trending market. Liquidation of positions often occurs before the weekend, with positions being re-entered on the first day of the week. Finally, volume is heavier on a triple witching day, when stock-index futures, stock-index options and stock options all expire on the same day.

In a nutshell

Volume and open interest are integral measures to guide one's trading decision on the futures markets, but as always, these indicators should be considered in relation to extraneous market events.

All the very best in your trading endeavors!