Introduction: Volume and Open Interest

Secondary indicators, Volume, Open Interest, How to find futures markets, Price action

Course: [ Technical Analysis of the Financial Markets : Chapter 7: Volume And Open Interest ]

Most technicians in the financial markets use a multidimension­al approach to market analysis by tracking the movement of three sets of figures, price, volume, and open interest. Volume analysis applies to all markets.

INTRODUCTION

Most technicians in the financial markets use a multidimension­al approach to market analysis by tracking the movement of three sets of figures, price, volume, and open interest. Volume analysis applies to all markets. Open interest applies primarily to futures markets. Chapter 3 discussed the construction of the daily bar chart and showed how the three figures were plotted on that type of chart. It was stated then that even though volume and open interest figures are available for each delivery month in futures markets, the total figures are the ones generally used for forecast­ing purposes. Stock chartists simply plot total volume along with the accompanying price.

Most of the discussion of charting theory to this point has concentrated mainly on price action with some mention of vol­ume. In this chapter, we'll round out the three dimensional approach by taking a closer look at the role played by volume and open interest in the forecasting process.

VOLUME AND OPEN INTEREST AS SECONDARY INDICATORS

Let's begin by placing volume and open interest in their proper perspective. Price is by far the most important. Volume and open interest are secondary in importance and are used primarily as con­firming indicators. Of those two, volume is the more important.

Volume

Volume is the number of entities traded during the time period under study. Because we'll be dealing primarily with daily bar charts, our main concern is with daily volume. That daily volume is plotted by a vertical bar at the bottom of the chart under the day's price action. (See Figure 7.1.)


Figure 7.1 Notice that the volume bars are noticeable larger as prices are rallying (see circles). That means that volume is confirming the price rise and is bullish.

Volume can be plotted for weekly bar charts as well. In that case, total volume for the week would simply be plotted under the bar representing that week's price action. Volume is usually not used, however, on monthly bar charts.

Open Interest in Futures

The total number of outstanding or unliquidated contracts at the end of the day is open interest. In Figure 7.2, open interest is the solid line plotted on the chart under its corresponding price data for the day, but above the volume bars. Remember that official volume and open interest figures are reported a day late in the futures markets and are, therefore, plotted with a one day lag. (Only estimated volume figures are available for the last trading day.) That means that each day the chartist plots the high, low, and closing price bar for the last day of trading, but plots the offi­cial volume and open interest figures for the previous day.

Open interest represents the total number of outstanding longs or shorts in the market, not the sum of both. Open interest is the number of contracts. A contract must have both a buyer and a seller. Therefore, two market participants—a buyer and a seller— combine to create only one contract. The open interest figure reported each day is followed by either a positive or negative number showing the increase or decrease in the number of con­tracts for that day. It is those changes in the open interest levels, either up or down, that give the chartist clues as to the changing character of market participation and give open interest its fore­casting value.

How Changes in Open Interest Occur. In order to grasp the signifi­cance of how changes in the open interest numbers are interpret­ed, the reader must first understand how each trade produces a change in those numbers.

Every time a trade is completed on the floor of the exchange, the open interest is affected in one of three ways—it increases, decreases, or stays unchanged. Let's see how those changes occur.


In the first case, both the buyer and seller are initiating a new position and a new contract is established. In case 2, the buyer is initiating a new long position, but the seller is merely liq­uidating an old long. One is entering and the other exiting a trade. The result is a standoff and no change takes place in the number of contracts. In case 3, the same thing happens except this time it is the seller who is initiating a new short and the buyer who is only covering an old short. Because one of the traders is entering and the other exiting a trade, again no change is pro­duced. In case 4, both traders are liquidating an old position and the open interest decreases accordingly.

To sum up, if both participants in a trade are initiating a new position, the open interest will increase. If both are liquidat­ing an old position, the open interest will decline. If, however, one is initiating a new trade while the other is liquidating an old trade, open interest will remain unchanged. By looking at the net change in the total open interest at the end of the day, the chartist is able to determine whether money is flowing into or out of the market. This information enables the analyst to draw some con­clusions about the strength or weakness of the current price trend.

General Rules for Interpreting Volume and Open Interest

The futures technician incorporates volume and open interest information into market analysis. The rules for the interpretation of volume and open interest are generally combined because they are so similar. There are, however, some distinctions between the two that should be addressed. We’ll begin here with a statement of the general rules for both. Having done that, we'll then treat each one separately before combining them again at the end.


If volume and open interest are both increasing, then the current price trend will probably continue in its present direction (either up or down). If, however, volume and open interest are declining, the action can be viewed as a warning that the current price trend may be nearing an end. Having said that, let's now take a look at volume and open interest separately. (See Figure 7.2.)


Figure 7.2 A daily chart of crude oil futures shows volume and open interest (solid line). The open interest line is rising as prices are falling, which is bearish.

 

Technical Analysis of the Financial Markets : Chapter 7: Volume And Open Interest : Tag: Technical Analysis, Stocks : Secondary indicators, Volume, Open Interest, How to find futures markets, Price action - Introduction: Volume and Open Interest