Blowoffs and Selling Climaxes

BLOWOFFS AND SELLING CLIMAXES

One final situation not covered so far that deserves mention is the type of dramatic market action that often takes place at tops and bottoms—blowoffs and selling climaxes. Blowoffs occur at major market tops and selling climaxes at bottoms. In futures, blowoffs are often accompanied by a drop in open interest during the final rally. In the case of a blowoff at market tops, prices suddenly begin to rally sharply after a long advance, accompanied by a large jump in trading activity and then peak abruptly. (See Figure 7.12.) In a selling climax bottom, prices suddenly drop sharply on heavy trading activity and rebound as quickly. (Refer back to Figure 4.22c.)

COMMITMENTS OF TRADERS REPORT

Our treatment of open interest would not be complete without mentioning the Commitments of Traders (COT) Report, and how it is used by futures technicians as a forecasting tool. The report is released by the Commodity Futures Trading Commission (CFTC) twice a month—a mid-month report and one at month's end. The

Figure 7.12 A couple of blowoff tops in coffee futures. In both cases, prices rallied sharply on heavy volume. The negative warnings came from the decline in open interest (solid line) during both rallies (see arrows).

report breaks down the open interest numbers into three cate­gories—large hedgers, large speculators, and small traders. The large hedgers, also called commercials, use the futures markets primarily for hedging purposes. Large speculators include the large commodity funds, who rely primarily on mechanical trend­following systems. The final category of small traders includes the general public, who trade in much smaller amounts.

WATCH THE COMMERCIALS

The guiding principle in analyzing the Commitments Report is the belief that the large commercial hedgers are usually right, while the traders are usually wrong. That being the case, the idea is to place yourself in the same positions as the hedgers and in the opposite positions of the two categories of traders. For example, a bullish signal at a market bottom would occur when the com­mercials are heavily net long while the large and small traders are heavily net short. In a rising market, a warning signal of a possi­ble top would take place when the large and small traders become heavily net long at the same time that the commercials are becoming heavily net short.

NET TRADER POSITIONS

It is possible to chart the trends of the three market groups, and to use those trends to spot extremes in their positions. One way to do that is to study the net trader positions published in Futures Charts (Published by Commodity Trend Service, PO Box 32309, Palm Beach Gardens, FL 33420). That charting service plots three lines that show the net trader positions for all three groups on a weekly price chart for each market going back four years. By providing four years of data, historical comparisons are easily done. Nick Van Nice, the publisher of that chart service, looks for situations where the commercials are at one extreme, and the two categories of traders at the other, to find buying and selling opportunities (as shown in Figures 7.13 and 7.14). Even if you don't use the COT Report as a primary input in your trading decisions, it's not a bad idea to keep an eye on what those three groups are doing.

OPEN INTEREST IN OPTIONS

Our coverage of open interest has concentrated on the futures markets. Open interest plays an important role in options trading as well. Open interest figures are published each day for put and call options on futures markets, stock averages, industry indexes, and individual stocks. While open interest in options may not be interpreted in exactly the same way as in futures, it tells us essen­tially the same thing—where the interest is and the liquidity. Some option traders compare call open interest (bulls) to put open interest (bears) in order to measure market sentiment. Others use option volume.

Figure 7.13 This weekly chart of S&P 500 futures shows three buy signals (see arrow). The lines along the bottom show the commercials (solid line) heavily net long and the large speculators (dashed line) heavily net short at each buy signal.

PUT/CALL RATIOS

Volume figures for the options markets are used essentially the same way as in futures and stocks—that is, they tell us the degree of buying or selling pressure in a given market. Volume figures in options are broken down into call volume (bullish) and put volume (bearish). By monitoring the volume in calls versus puts, we are able to determine the degree of bullishness or bearishness in a mar­ket. One of the primary uses of volume data in options trading is the construction of put/call volume ratios. When options traders are bullish, call volume exceeds put volume and the put/call ratio falls. A bearish attitude is reflected in heavier put volume and a higher put/call ratio. The put/call ratio is usually viewed as a con­trary indicator. A very high ratio signals an oversold market. A very low ratio is a negative warning of an overbought market.

Figure 7.14 This weekly chart of copper futures shows three sell signals marked by the arrows. Each sell signal shows net long positions by the two categories of speculators and a net short position by the commercial. The commercials were right.

COMBINE OPTION SENTIMENT WITH TECHNICALS

Options traders use open interest and volume put/call figures to determine extremes in bullish or bearish sentiment. These senti­ment readings work best when combined with technical measures such as support, resistance, and the trend of the underlying mar­ket. Since timing is so crucial in options, most option traders are technically oriented.

CONCLUSION

That concludes our coverage of volume and open interest, at least for now. Volume analysis is used in all financial markets—futures, options, and stocks. Open interest applies only to futures and options. But, since futures and options are traded on so many stock market vehicles, some understanding of how open interest works can be useful in all three financial arenas. In most of our discussions so far, we've concentrated on daily bar charts. The next step is to broaden our time horizon and to learn how to apply the tools we've learned to weekly and monthly charts in order to perform long range trend analysis. We'll accomplish that in the next chapter.