Use open interest to find bull/bear signals

Traders often use open interest as an indicator to confirm trends and trend reversals for both the futures and options markets. Open interest represents the total number of open contracts on a security. You can gauge the strength of the market by using volume in conjunction with open interest.

Here we will look at the importance of the relationship between volume and open interest in confirming trends and their impending changes.

Factors used in open interest bull/bear signals

Volume, often used in conjunction with open interest, represents the total number of shares or contracts that changed hands in a one-day trading session. The greater the amount of trading during a market session, the higher the trading volume. Volume represents a measure of intensity or pressure behind a price trend.

Open interest is the number of transactions that are not settled at a given moment for a specific asset. An increase in open interest indicates that additional or new money is flowing into the market because more traders opened positions for the day than closed them. In contrast, a decrease in open interest indicates that money is flowing out of the market as more positions close than open.

Price action is the trend that prices have taken for the period being evaluated. Price action is related to volume, and both of these factors are related to open interest because volume and price follow each other and create interest in opening or closing positions.

So, many traders combine price action, volume and open interest to create bullish or bearish market signals.

How to use Bull/Bear open interest signals

The basic rules for price action, volume and open interest are demonstrated in the following table:

Price action that increases during an uptrend and rising open interest is interpreted as new money entering the market. This reflects new purchases, which are considered bullish. If the price action rises and open interest and volume fall, short sellers covering their positions cause the price to rise. Therefore, money leaves the market. Traders consider this a bearish sign.

If prices are in a downtrend and open interest and volume are rising, some chartists believe that new money is coming into the market. They think this pattern shows aggressive new short selling. This scenario is expected to lead to a continuation of a downtrend and bearish condition.

Finally, if open interest and volume fall and prices fall, this is likely caused by disgruntled long position holders being forced to liquidate their positions. Some technicians view this scenario as a strong position because they think the downtrend will end once all the sellers have closed their positions.

According to the theory, high open interest at a market top and a dramatic price drop should be considered bearish. This means all bulls that bought near the top of the market are now in a losing position. Their panic to sell keeps the price action under pressure.

Criticism of Open Interest Bull/Bear Signals

Other analysts interpret some of these signals quite differently, mainly because they place less value on momentum. In particular, excessive short interest is seen by many as a bullish sign. Short selling is generally unprofitable, especially after a significant downward movement. However, naive price chasing often leads less informed speculators to short an asset after a decline. When the market goes up, they have to cover. The typical result is a short squeeze followed by a violent rally.

In general, momentum investors are not nearly as good at predicting trend reversals as their contrarian counterparts. While it is true that there is generally more buying and bullish price action on the way, the information does not help investors decide when to sell. In fact, volume often increases before, during, and after major market tops.

Some of the most respected indicators are based on conflicting views. The most relevant signal here may be the put/call ratio, which has a good track record of predicting reversals. The relative strength indicator is another useful contrarian technical indicator.

The Bottom Line

No need to study a chart for rule based signals. If you are a new technician trying to understand the basics, check out many different theories and indicators. What works for some assets and investment styles will not work for others. Look at stocks, bonds, gold and other commodities and see if a particular indicator works for a particular application.

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