Today, I plan to share the investment insights Benjamin Graham, Warren Buffet’s mentor, gleane...
Understanding Open Interest
12/03/2009 12:30 pm EST
The explosion of interest in the commodity markets has caused a large influx of new commodity traders. Most bring the same set of analytical tools to the commodity markets as they have used in stocks or currencies. This is fine for the most part, but there are a few additional tools that can benefit commodity traders. One is the open interest (OI), which may be a familiar concept to option traders, but not to those who trade stocks, and certainly not cash forex traders.
The dramatic rallies in some of the commodity markets—such as gold and sugar in 2009— reinforce the importance of watching the open interest. The chart of the February 2010 Comex gold shows that open interest started rising this summer well ahead of the upside breakout from the continuation pattern. (I have used a semi-log plot of the OI to better illustrate its trend.) This is a sign of strong accumulation and is very bullish. The chart reflects data through the close on November 30 as the OI is still expanding, which indicates that new long positions are being established. Below is an excerpt from an earlier article that explains in more detail the interpretation of the open interest.
Open interest is the number of contracts or options existing at the end of a trading session. You should note that every contract has a buyer and a seller who together make up one contract. The open interest should be monitored along with the price and volume action to determine whether an uptrend or downtrend is strong or weak. For example, if prices are moving higher and opening interest is rising, it is considered bullish as new positions are being created. Conversely, if prices are rising and the open interest is declining, then it is negative as the drop in open interest indicates that short positions are being covered. In this situation, the chances of a rally failure are greater than in the previous example where the open interest was rising along with prices. If prices are declining and open interest is rising, then it adds more fuel to the downtrend as new sellers are helping to push prices lower. If prices are declining and the open interest is falling, then it is more likely that the price decline is a result of long liquidation rather than new selling. This would be consistent with a correction within an uptrend.
Crude oil has been in a spectacular bull market for the past ten years, and as prices were bottoming, the open interest gave some valuable clues. The daily chart of the July 1999 crude oil contract shows the decline in mid-February to a low of $11.90 (point a), which was followed by a sharp, six-day rally back to the long-term downtrend at point b. On this rally, the open interest (red line) increased about 10%. One has to realize that if one contract is expiring, then it is natural to see the open interest in the other contracts expand. However, since we are looking at the July contract, this increase in February does suggest additional buying. On March 10, point c, crude closed above the resistance at $14.00 per barrel (line 1) and the open interest was over 30% higher than it was at the February lows. The chart shows that crude prices accelerated to the upside over the next four weeks and the open interest continued to expand. By early April it had more than doubled. This expansion was one of the several bullish technical factors that suggested crude oil might be forming an important low.
NEXT: Study Continues with Analysis of Gold and Natural Gas|pagebreak|
Natural gas is also a widely traded and volatile commodity that often seems to move in the opposite direction of crude oil. For this example, I will use the December 2006 contract as natural gas had spiked to over 15.00 in 2005 and was in a downtrend as 2006 began. The rally in December 2005 had failed in the 12.00 area (line a), and then in mid- April, (line b) natural gas again rallied, testing the 11.50 area, thereby forming the downtrend, line 1. During this period (line a to line b), the open interest doubled. Natural gas once again rallied back to the 11.50 area in July and tested the downtrend, line 1. On this rally, the open interest expanded even more dramatically, line 3. As natural gas turned lower, volume increased, suggesting heavier (circle c) selling. The violation of key support at line 2 in September was supported by high volume and rising opening interest. The width of the trading range gave a downside target in the 6.60- 6.80 area. The high open interest prior to the break of support likely accentuated the decline as traders appeared to be well positioned on the short side.
I have found that the open interest is especially interesting during the formation of continuation patterns. If prices are forming a triangle within an uptrend and the open interest is declining, then often times, the breakout will not be that impulsive. On the other hand, if prices are forming a triangle or flag (within an uptrend) and the open interest is expanding, then a more dramatic breakout is likely. In Figure 3, we have a daily chart of April 2008 Comex gold, which formed a triangle formation during November and December of 2007. As prices were within the triangle, the open interest gradually expanded. As prices broke out of the triangle in late December and early January, the open interest increased dramatically along with the volume. This was consistent with a strong rally.
Volume and open interest need to confirm each other for the strongest signals. In the gold chart above, the breakout of the continuation pattern occurred on about five times the normal volume and the open interest had risen sharply. If instead prices were rising and the volume and open interest were declining, it would be consistent with a weak uptrend. In a down market, the most bearish environment would be when both open interest and volume were rising as prices declined since this would indicate heavy selling pressure.
One way to monitor changes in the open interest is to run a rate of change (ROC) on the open interest. In Figure 4, I have added a ten-period ROC of the open interest to the crude oil chart previously discussed. From December until early February, the ROC was declining at about the same rate as prices. Just after the February lows (point a), the downtrend in the ROC, line 1, was broken. The ROC continued to increase as the downtrend, line 2, was overcome. By the time more important resistance in the $14 area was surpassed (point b), the ROC was rising more sharply and the volume was expanding. One of the problems with momentum, or rate of change, studies is that during strong uptrends or downtrends, they will diverge from prices. This is what occurred in early April as the ROC spiked to the 70 area and then turned lower even though the open interest was still in a solid uptrend. Because of these limitations, I have found the ROC on the open interest to be most useful when there is evidence of a top or bottom, as well as during the formation of a continuation pattern.
If you are trading futures or options, you need to determine the level of the open interest before taking a position, and also analyze the pattern in the open interest before establishing a futures position. If you would like to explore open interest analysis in more detail, you might want to read this article on the Herrick Payoff Index, developed by John Herrick, as it is one of the few indicators that effectively combines price, volume, and open interest to measure money flowing in or out of a commodity.
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