Introduction: Volume and Open Interest

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.