Basics of Volume and Open Interest

[Trader X]

Basics of Volume and Open Interest
Trader X
Chicago, IL

It's my opinion that successful trading for the long term is not possible without a sound understanding of both trader psychology and market psychology. Often individual traders focus so heavily on the results they are seeking that they forget that every other trader out there is doing the same thing: attempting to profit from price action. But it is the very nature of this conflict that creates price action because it is physically impossible for every executed trade to show a profit once each contract executed is liquidated. Futures trading is structured as a zero-sum environment. This means that in order for a price to print, BOTH a buying order and a selling order must be matched at the current traded price; otherwise no trade happens and no new price will print. Therefore, the issue of potential price change from orders being placed and filled is what ultimately creates the price action traders are attempting to capture as a profit to their individual accounts. As competing orders are matched, resulting in EITHER more futures contracts initiating a new position or closing an old open position (regardless of profit or loss to an individual account) is the issue of VOLUME and OPEN INTEREST.

One of basics to better understanding VOLUME and OPEN INTEREST is to understand it from the point of view that it represents individual traders who all can’t be right as far a profit is concerned. Someone must liquidate to take a loss. Since most traders have a large portion of losing trades as their results over time; it follows that a lot of what is causing a price change MUST be losing trades being liquidated. By understanding that a large portion of VOLUME and OPEN INTEREST (when it changes) must mean a CHANGE in the value of someone’s account balance; it becomes a bit better to understand where and when a turn in the market might be coming. Why? Because the people who helped put prices where they are now may have left the market completely; someone else has taken their place or not—that person has a completely different point of view on the market price and he might be in the wrong place too. He will liquidate sooner or later as well. With that in mind, let’s discuss someone the basics of VOLUME and OPEN INTEREST.

VOLUME is the total number of contracts being trading for a period of time. You can think of VOLUME as the AMOUNT of orders passing through the market place as a total; most commonly calculated on a per day basis (daily VOLUME)

OPEN INTEREST is the total number of contracts that remain open and held through at least one trading day (Overnight at least) You can think of OPEN INTEREST as the number of contracts someone is willing to hold at least for a period of time needed to realize a profit or loss.

Prices do not have to move in order for EITHER VOLUME or OPEN INTEREST to change; but usually a change in EITHER VOLUME or OPEN INTEREST will create a price change or signal that a change in price is coming. The reason a change in VOLUME or OPEN INTEREST can signal a change in price or create a change in price is because as the price moves—that movement is creating an open-trade gain or loss to someone and sooner or later that someone will need to liquidate his position and leave the market. It doesn’t really matter what the individual result to any one account might be; the fact is—you can’t “win” forever or “lose” forever. Sooner or later everyone must liquidate. This is why VOLUME and OPEN INTEREST will change. Traders are initiating and then liquidating their positions. It is the CHANGE that signals where a potential price reversal might be developing.

When VOLUME is HIGH; individual traders in large numbers are participating.

When VOLUME is LOW; traders are not participating to a large degree.

When OPEN INTEREST is RISING; traders are opening positions and assuming the risk that price will create a gain for them over at least one day.

When OPEN INTEREST is FALLING; traders are closing positions (liquidating) and they are EITHER accepting their loss or taking their profit.

The study of VOLUME and OPEN INTEREST is the study of “Who is participating and are they getting in or out with a gain or loss?” Discerning what this means to potential price movement coming over the next period of time forward is where VOLUME and OPEN INTEREST can be a good clue as to whether a market is ready to fall in price or rise in price.

Common Potential Meanings from Volume and Open Interest Changes

Price Rising, VOLUME dropping and OPEN INTEREST dropping:

Market is running out of traders willing to open or hold an OPEN LONG. Traders are liquidating both loosing short positions and closing winning long positions. A higher probability the market is set to retrace in price lower at some point forward.

Should prices be falling when this scenario develops, the market has a higher probability of a price rise at some point forward.

Price Rising, VOLUME rising and OPEN INTEREST rising:

Market is attracting larger numbers of traders willing to open positions from the long side and hold them. Traders are more confident that prices will continue to climb in favor of a working long. This scenario is a good clue that UPTREND is secure and that the trend may continue further for a period of time.

Should this scenario develop while prices are falling, it is a good indication that DOWNTREND is secure and that the trend may continue for a period of time.

Price Rising, VOLUME dropping and OPEN INTEREST rising:

Market is attracting LATE buyers and EARLY shorts; market is vulnerable to a sharp correction but likely that that correction will be bought creating a buy point for UPTREND.

If this scenario should develop while prices are dropping, it is a good indication that a sharp rally against DOWNTREND will develop creating a sell point for DOWNTREND.

Price Rising, VOLUME rising and OPEN INTEREST falling:

Market has a lot of traders initiating from both sides but larger traders may be liquidating into the higher prices. The market may be vulnerable to large price swings as shorter-timeframe traders attempt to trade from both sides of the market but liquidating before end-of-day. Often a signal of a market turn near-term or continued volatility. More common at significant tops (or bottoms).

Should this scenario develop as prices are dropping, it is still the same quality of market action. Often this is a sign of a significant bottom.

It should be noted that a brief discussion of the basics of VOLUME and OPEN INTEREST cannot take the place of deeper study into market structure. V/OI is only one clue to potential market price action and no market condition is 100% definable from simply a brief understanding of the V/OI picture at any one point in time. V/OI is best used as confirmation tool when selecting price points that you personally expect the market to move away from creating a potential opportunity.

In closing, V/OI can be a powerful tool to help uncover good directional potential in any market you are trading. As someone serious about building a strong market presence you would be served best if you made a commitment to learning how this critical series of indicators can work. Next month, we will discuss the Commitments of Traders reports produced by the CFTC. Often misunderstood, when combined with a solid understanding of V/OI you have a good confirmation clue that something is changing across a broad range of market participants. Good Luck and Good Trading.



BIO and Links:

Trader X is a self-taught and self-educated futures, options and FOREX trader operating from Chicago, IL. USA. He has authored an autobiography of his learning experience which is available at Welcome to Dancing With Lions a FREE sample chapter is included on the site for review. He also produces a FREE monthly market newsletter “Trader Insight”, email traderx@dancingwithlions. com to be placed on the email list. Trader X is available for more in-depth discussion on all trading topics and responds to all inquiries personally. He does not remarket or resell email information.


Trading Futures, Options on Futures, and Foreign Exchange involves substantial risk of loss and may not be suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change at any time. The information contained is this article does not constitute a solicitation to buy or sell by the author and is not to be available to individuals in a jurisdiction where such availability would be contrary to local regulation or law.

[cooter]

Interesting reading.

You've shared the V/OI matrix for when price is rising.

Could you do the same for when price is falling?

Thanks for this topic.

[notouch]

Open interest and the CTFC reports are definitely helpful in understanding the market but only as a background to price and volume analysis I find. Open interest can decline for a long time before price starts to reverse and speculative positions can be at extreme levels for a long time before a reversal. Unless you only trade the weekly charts it's difficult to actually use these in your trading.

[torero]

I agree, everyone talks about OI, but it seems to lag alot or if it's early, the price action don't confirm them for a good while.

[cooter]

Still looking to hear from the ever-elusive Trader X on the other half of this matrix for Volume and Open Interest when price is dropping.

Can anyone fill in the blanks here?

e. Price Falling, VOLUME dropping and OPEN INTEREST dropping:

f. Price Falling, VOLUME rising and OPEN INTEREST rising:

g. Price Falling, VOLUME dropping and OPEN INTEREST rising:

h. Price Falling, VOLUME rising and OPEN INTEREST falling: