“VOLUME. AND OPEN INTEREST KENNETH H. SHALEEN Sear aaCHAPTER 3 OPEN INTEREST 0 pen interest (Ol) is the summation of all unclosed purchases or sales at the end of a trading session. Confusion concerning the definition of open interest can be avoided by remembering this simple equality: Long OI = Short OI = Total OI Futures trading is a zero sum game: for every dollar in there is a dollar out. Admittedly, the exchange clearing house and member firms scoop a little off the top; but, for every open position in a futures market there has to be an opposite position. At the end of each trading session, the long open interest, by definition, must equal the short open interest. Published open interest figures are similar to those for volume in that what is reported by the clearing house to the public, press, and quote vendors is one side only. HOW OPEN INTEREST CHANGES Open interest changes from one trading session to the next; these fluctua- tions fall into one of three categories: 1) Increase, 2) Decrease, or 3) No Change. Each of the three situations will be examined in the following example. For this illustration, it does not matter whether prices moved up or down. What is necessary is that a “significant” price change oc- curred. While no specific definition of what constitutes significant will be given, it is safe to assume that the definition begins at more than five 21ae Chapter 3 minimum price tics. The technical ramifications of these changes will be apparent later in this chapter when detailing the ideal healthy price up- trend or downtrend. Example: Prior Day’s Total Open Interest = 180,000 Answer the question: Who is getting in or out of the market? Case One: Open Interest Increases Total Open Interest now at 3,000 New Long Contracts 183,000; a change of +3,000 and 3,000 New Short Contracts Case Two: Open Interest Decreases Total Open Interest now at 2,000 Long Contracts Sold Out 178,000; a change of -2,000 and 2,000 Short Contracts Bought Back Case Three: Open Interest Unchanged Total Open Interest now at In this situation, the trader 180,000; unchanged would not know exactly what changing of positions occurred. In Case One, new positions on both sides are increased. In Case Two, both sides are liquidating. In Case Three, it is not obvious what changes in the make-up of participants is taking place. Case Three would be an unlikely occurrence in a market with this magnitude of open interest. To illustrate the concept, an additional piece of information can be introduced into this scenario that would not be available to the analyst. If it was known that one new position (whether long or short) was placed, what else had to happen during the trading session? There had to be one liquidation. Unchanged open interest means that the same number of partici- pants (in terms of contracts) are in the market. There may have been some changing of positions. Old losing positions may have been meetingOpen Interest 23 margins calls. New positions may have been initiated. What is important is that “fuel” is available to sustain the price trend. SIGNIFICANCE OF OPEN INTEREST For every profit dollar in futures trading there must be a loss dollar. Open interest is a reflection of this very important concept. If a futures trader makes a correct market judgment, where do the funds come from to pay off his winning position? The funds come from the loser. This may sound harsh, but it is a fact of life in every futures market. A techni- cian should be very interested in what the losers are doing. The change in open interest is the key to this puzzle. The analysis of open interest changes is important for at least three reasons: Open Interest Provides Fuel to Sustain a Price Move The analogy of fuel to the market is like that of fuel to a fire. If the fuel is removed from a fire, the fire will go out. If fuel is removed from a price trend, the trend will change. Fuel in a futures market is provided by the losing positions. When open interest declines, fuel is being removed and the prevailing price trend is running on borrowed time. For a healthy, strong price trend (either up or down) to continue, open interest ideally should increase, or at least not decline. This is so important a concept that remembering the word “fuel” as a surrogate for open interest will place a trader ahead of 80 percent of all futures traders worldwide! Open Interest Indicates the Existence of a Difference of Opinion There is nothing that creates a market more than a difference of opinion. This is reflected in a willingness to take an open position and hence an increase in open interest. Economists state that any market place searches for an equilibrium price—the intersection of the supply and demand curve at a price that “clears” the market. What if a futures market was at the theoretical equi- librium and the entire dealing world knew it? What would be the level of open interest? Zero. There would be no need for hedgers to shift risk or speculators to put their hard earned money on the line to outguess the market direction. But no one knows where equilibrium is; it is always shifting. Open interest measures the difference of opinion and, more im- portantly, how it is changing.24 Chapter 3 For instance, a borrower of funds tied to a floating rate (a potential short hedger) knows that if rates rise, financial difficulty awaits in the form of higher costs. The borrower does not know which way rates are going, but wants to shift the risk of increasing rates. A speculator may think he can outsmart the market and decides rates are going down. Both the borrower and speculator have a willingness to put on an open position. Increasing open interest is the signal that profits will be available (from the loser) as fundamental supply and demand factors move inter- est rates toward a new equilibrium. What is important to understand is that the difference of opinion creates a market that can sustain a signifi- cant price move. Open Interest Determines if the Losers are Being Replaced Technicians do not care if a losing position is being financed by meeting margin calls and throwing more money at the market or if one loser steps aside and new blood comes in to take his place. What matters is that the funds are being posted at the clearing house. The losers are nec- essary to pay off the traders with the correct market judgment. When the losers decide that they “don’t want to play the silly game any more” and leave the market, open interest will decline. Obviously the losers pay the price for their misjudgment, but what is of importance to the technician is that declining open interest means the prevailing price trend has be- come very unhealthy. IDEAL HEALTHY PRICE UPTREND Figure 3-1 represents a healthy price uptrend that is expected to con- tinue: Both the bulls and the bears are increasing their positions; open interest is increasing. The longs, however, are in control. The longs are the smart money. ‘The technician always attempts to monitor what the smart money is doing. In an uptrending market, this is obviously the bulls. If the longs are increasing their positions and the losers (shorts) are being replaced, open interest will be expanding. The price upmove is technically healthy. When open interest increases along with price, existing longs may be adding to their profitable positions and/or new longs may be joining the bull bandwagon. The additional short sellers may be existing shorts adding to their losing positions and/or new short sellers entering theOpen Interest 25 Figure 3-1 Healthy Price Uptrend PRIGE UP } t O.1. UP ne PRICE ‘OPEN INTEREST market. It does not matter which situation is occurring; both represent a healthy price uptrend, Upon introduction to this concept, many students of technical anal- ysis have difficulty believing there is a “strong hand.” After all, aren't there an equal number of longs and shorts? The problem is being able to distinguish who is in control, The direction of the price move determines which contingent is in control. Figure 3-2 shows the coincident nature of price and open interest during the inflationary driven agricultural mar- kets of the early 1980's. The Plywood chart in Chapter Two (Figure 2-3) also displays coincident price and open interest changes in a market that the public liked to trade from the long side. The internal characteristics shown in Figure 3-3 are very different from those in Figure 3-2. In Figure 3-3, price is increasing, but open interest is falling. The price uptrend here should mot be expected to éon- tinue. When open interest declines as prices increase, whal are the longs doing? They are selling out their long positions, taking profits. What are the shorts doing? They are buying back, covering or taking their losses.26 Chapter 3 ire 3-2 Healthy Bull Market SOYBEAN MEAL MAR 1981 CBOT (OPEN INTEREST K ae ah sth Mang ith CURRENT (OPEN INTEREST balan 14 281125 9 23-6 20 4 18 1 1529-1228 102 7 215 19 2 16 0 19 OF Man APR MAY JUNE JULY AUG” SEPT. OCT. NOV. DEC. JAN. FEB Open Interest: Increases on Price Updays Decreases on Price Sellotts Who has been correct in their market judgment all the way up? The longs. Who has been dead wrong all the way up? The shorts. The techni- cian wants to side with the smart money. The smart money is saying that prices have gone high enough. The losers are either so confused or do not have any money left (probably both) that they are throwing in the towel. The price upmove is coming from poor buying; this is a weak technical situation. The price uptrend is expected to reverse. Figure 3-4 shows the early warning signal of open interest declining and the liquidation that occurred after a price run-up. This was the signal that the bulls were no longer enamored with this market.Open Interest 27 Figure 3-3 Unhealthy Bull Market PRIGE UP O.1. DOWN PRICE OPEN INTEREST A Caveat Before assuming the early warning signal of open interest declining will always signal an impending price top, a caveat is appropriate. The signal of open interest declining prior to a price top does not occur all that often, perhaps only 15-20 percent of the time. ‘Although the open interest decline may not flash the warning signal in a high percentage of the price tops, it remains important. Failure to monitor open interest changes deprives a futures trader from obtaining vital insight as to what may be occurring. Referring to price only does not portray what is/may be taking place “below the surface.” IDEAL HEALTHY PRICE DOWNTREND The ideal healthy bear market is characterized by prices moving lower on increasing open interest. This is seen in the theoretical diagram in Figure 3-5.28 Chapter 3 Figure 3-4 Early Warning Signal WHEAT DEC 1983 K.C. BU ly ie a ie ! I hy sles ty o1 Ioky) i. jopetuinrenesroecunna =} a0 Mil \ Whip prow to 1H Price se.tore aus, iy wo open mrenest 7 OEEOueRve) CURRENT OPENINTEREST._\. vot. ra as ‘BUS. 100 EE aan a ti 5 6 2 6 2 3 t7 1 as ef iz 20 8 za 7 a 4 18 FEB NAR APR MAY JUNE JULY AUG, SEPT. OCT NOW.Open Interest 29 Figure 3-5 Helathy Price Downtrend 0.1. UP PRICE { {t Ne PRICE DOWN ‘OPEN INTEREST When prices settle lower than the previous close on increasing open interest, the shorts are in control. The short sellers are pressing their win- ning positions. The longs are bottom picking and adding to losing posi- tions. The bulls are “long and wrong’—making cannon fodder of themselves and providing fuel to sustain the price downtrend. This is seen in the latter stages of the bear market in corn illustrated in Figure 36. The ideal healthy bear market of price down on increasing open interest would be expected to continue as long as open interest does not begin to decline. When the smart money (the shorts) decides to take profits, liquidation in total open interest will reflect this condition. Open interest declining would mean there is less conviction concerning the probable continuation of the price downtrend and less fuel to sustain the30 Chapter 3 Figure 3-6 Healthy Price Downtrend ‘80 CORN DEC 1985 CBOT 20 40 TOTAL OPEN INTEREST A 216 VOLUME (AI Contracts) NOL OPEN INTEREST US OPEN INTEREST (ra79-1988 AVG } = aN 8 @ 8 | om ee A oe ee. te Hk ke ee JAN FEB OMAR APR MAY «JUNE | RIL AUG, «SEPT OCT, Open Interest: Increases on Prica Downdays, Decreases on Price UpdaysOpen Interest 31 price downtrend. If total open interest begins declining as prices move lower, the early warning signal of an impending trend reversal is flashed. This situation is analogous to the declining open interest signal prior to a price top. A Caveat The ideal healthy bear market is found with far less frequency than the ideal healthy bull market. This is due to the idiosyncrasy of the “public” toward trading. They do not like a bear market and are reluctant to par- ticipate in one. Even if a salesman telephoned a potential client and explained he could make just as much money on the way down and often in a shorter time period because markets tend to fall faster than they go up, the client’s response would be, “Call me when it gets to the bottom and then Yl buy it.” The public has a definite tendency to avoid a bear market! The technical ramifications are such that a futures analyst is pleased if he can find open interest at least remaining flat during a bear market. In this situation, the losers are being replaced and the fuel is at least remaining constant. A more likely bear market scenario is finding open interest declin- ing. Declining price and declining open interest are classic characteristics of a liquidating market. This situation puts the prevailing price trend in a weak technical condition. The “bottom line” is if traders wait to short a fu- tures market only if open interest is expanding, they will not be on the short side very often. This is especially true of futures contracts that the public likes to trade from the long side. These include the traditional agricultural com- modities (grains and livestock) and the metals. Traders must think about idiosyncrasies peculiar to the specific mar- kets they trade. A price top on a spot Dollar-Mark chart in inter-bank dealing would look like a price bottom on a D-Mark futures chart. The price scales used are the reciprocal of each other. These, and other spe- cific traits, will be addressed for individual markets in Chapters Eight and Nine. SIDEWAYS PRICE ACTIVITY When prices are, in general, moving sideways in a choppy trading range, what use can be made of open interest changes? Relatively flat open in- terest along with sideways price activity is the most neutral condition; no32 Chapter 3 predictive price implication exists. Open interest increasing, however, does create conditions that are important to note. Price Steady, Open Interest Up When open interest increases, new bulls are buying (opening new longs) from new bears who are selling (opening new shorts). This is an aggres- sive posture from both sides. Prices are not expected to remain stagnant. Once prices breakout with a close outside a trading range, simply liqui- dating the losers should carry quotes a considerable distance. The techni- cal signal created when open interest increases as price moves sideways is one of preparedness because a breakout is eminent. There is a general rule of thumb for anticipating the probable extent of a price move that is often used by bar chartists: Once a breakout from a rectangular or triangular trading range has occurred, quotes are ex- pected to move beyond the breakout level by a distance equal to the vertical height of the trading range. When open interest is building prior to the breakout, it is safe to assume that this “height” measuring objec- tive is likely to be achieved. Price Steady, Open Interest Down Open interest declining is the definition of a liquidating market. Together with sideways price movement on the chart, the picture is certainly far from dynamic, But the technician should not be lulled into a sense that nothing is happening. This condition is most often associated with a market trying to change direction. If an upside breakout from a sideways trading range occurs, a tech- nician must see increasing open interest. This is necessary to be comfort- able in applying the height measuring objective. If a downside breakout occurs, the long liquidation (open interest down) often continues. Yet even in this technically weak condition, the traditional height objective is most often reached to the downside. The ideal situation is open interest expanding after the downside breakout; but it is not a necessary condition. The propensity of the public to favor the bull side of any market is once again the major influence. An Example The coffee futures chart in Figure 3-7 exhibits classic price and open in- terest interaction.Open Interest 33 Figure 3-7 COFFEE MAR 1990 CSCE | "iat \ olsTeapy HEALTHY DURING TRIANGULAR BECK: ‘CONSOLIDATION hia ill ih li 14 on fa) ee as > 14s 29 ta 87 APR MAY JUN wu mus SEP GT34 Chapter 3 1) The bulls were in control on the two price rallies of April and May; open interest expanded. 2) Dips in open interest preceded the price declines in late April and mid-June; this is the classic early warning signal. 3) Note the normal long liquidation that occurred as quotes moved lower after a rally. 4) A healthy bear market developed from late June onwards; open interest marched higher. 5) Open interest held flat at a relatively high level during the tri- angular consolidation from mid-August to late September; this gave classical bar chartists confidence that enough fuel was present to propel prices to the traditional height measuring ob- jective once a breakout occurred. CONVENTION An open interest scale is constructed at the bottom of each daily high- low-close futures bar chart. A dot marking the level of total open interest at the end of each trading session is posted directly under the price activ- ity. Connecting the daily postings yields a graphic portrayal of the changes in open interest. The change in open interest, not the absolute magnitude of open interest, is what is technically important. The Commodity Exchange of New York (COMEX) gold futures con- tract can be used as an example: Assume 180,000 contracts are reported as the total number of open positions. This 180,000 figure does not reveal how many separate entities are involved as large or small speculative traders, futures funds, or legitimate hedgers. What is known with cer- tainty is that 180,000 long positions (each representing a 100-oz contract) and 180,000 short positions are outstanding.and yet to be offset or ful- filled via the delivery process. Insight as to the category of participants can be obtained via the monthly Commitments of Traders Report. See Chapter Ten for a description and use of this report. SHORT INTEREST (EQUITIES) The concept of short interest in the U.S. stock market is completely dif- ferent from open interest in futures. In any equity market that allows short sales using borrowed stock, a short interest situation might exist.Open Interest 35 Short interest is the number of shares that have not yet been purchased to cover short sales. The borrowed stock must eventually be returned to the lender, Two schools of thought prevail as to what short interest implies: 1) either traders expecting a price decline could be initiating short sales or 2) the shares, sold short must eventually be bought back—hence a bullish condition. Increases in takeover activity and arbitrage have further clouded the issue of how: to interpret short interest statistics from an equity market.