HedgefundLIVE.com– The following is an excerpt from my upcoming research piece “Open Interest: The Most Important Indicator You Don’t Follow”
Open Interest: The number of outstanding contracts in a certain listed derivative
Figure 1.1: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:
Sell Long 0 -1 Sell Short +1 0 Buy Long Cover
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
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