Open Interest: The number of outstanding contracts in a certain listed derivative
While many traders follow action in the S&P 500 E-minis as a proxy for the overall market, only a handful of these traders track and interpret open interest figures. By knowing how many futures contracts are being created or closed out on a daily basis allows a trader gain a second layer of understanding to compliment his or her analysis of price action. To begin our discussion, lets discuss how contracts are created and how they are closed. Take a look at the matrix below:
0 -1Sell Short
In the matrix we can see four separate scenarios; one in which a contract is created, one in which a contract is closed, and two neutral events. First, a contract is created when Person A buys one contract from Person B who then becomes short one contract (bottom left quadrant). If person A sells his or her contract to Person C, it is simply a transfer of ownership and no contracts are created or closed (top left quadrant). Similarly, if Person B covers his contract and Person D shorts the same contract, there is no change in open interest (bottom right quadrant). Finally, lets return to our original example where Person A is long one contract and Person B is short one contract. If Person A sells his contract to Person B, thereby allowing him to cover, the contract is closed and open interest decreases by 1.
Rising vs. Falling Markets
On the surface, a change in open interest seems like a market neutral event (one individual is getting long while another is getting short); however, the indicator takes on significance in the context of market direction. First, let’s examine the implications of open interest figures in a rising market. Refer back to Figure 1.1; this scenario favours the bottom left quadrant.
While it is true that every contract bought is met with an equal number of short contracts, the fact that the market is moving higher suggests that the longs are price takers and the shorts are price makers. This implies that traders are aggressively getting long and willing to lift offers. On the other hand, if the market is rising as open interest is falling, it implies that the shorts are being squeezed and are aggressively covering their positions.
The same exact logic applies to analysing open interest in a declining market. If open interest is negative in tandem with the market, it favours the upper right hand quadrant of figure 1.1. Traders holding long futures are selling their positions more aggressively (by hitting bids) than short traders are covering their positions. In this scenario, the shorts are the price makers and the longs are price takers. Conversely, if open interest rises in a declining market, it suggests that traders are aggressively shorting futures contracts.
Interpreting the Figures
Now that we know the implications of positive and negative open interest figures, let’s discuss how the figures can be interpreted. In his classic book Technical Analysis for the Financial Markets, John Murphy provides a description of open interest that provides a basic framework for their interpretation. First, when open interest is rising in a rising market, it implies there are “real” buyers, individuals who are seeking to build a long position and will lift an offer to do so.
Murphy goes on to explain that this pattern is most effective in the early and middle stages of a market cycle. On the other hand, if open interest is negative as the market is rising, the primary upward force is provided by short covering; traders who are panicking out of a short position thereby driving the market higher. While a short covering rally may provide a temporary boost to the market, in the long term, “real” buyers will provide sustenance to a rising market and perpetuate the trend.
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