Open interest is a metric used by futures traders to study a market’s evolving liquidity. It’s the number of outstanding or open contracts facing a security at a specific point in time. The functionality of the indicator is extensive, readily applicable to both trend following and reversal trading approaches.
Identifying a security’s market state is a routine task that active traders perform every single day. Understanding whether price is trending, rotational, or pending breakout is an integral part of limiting risk while maximizing reward. Through giving us an idea of potential order flow, open interest is especially useful in predicting future levels of activity in a given product or market.
Trend Extension and Exhaustion
In practice, there are dozens of technical indicators that traders may use to identify whether a security’s price is in rotation, undergoing reversal, or trending. Open interest is among the most basic, addressing the question of market participation as it pertains to the sustainability of an ongoing fluctuation in pricing. Here are a few general guidelines that relate the number of open contracts in a market to bullish or bearish trend extension and exhaustion:
- Bullish: As the price of a security rises over time, trading activity typically remains robust. In the event the number of open contracts facing a security increases along with traded volumes and price, the prevailing bullish trend is likely to extend its range.
- Bearish: In the event a security’s price drops over time, sells orders are hitting the market regularly, promoting consistent trading volumes. As long as the number of outstanding contracts increases, price is likely to continue falling.
- Trend exhaustion/reversal: Determining when a market is overbought or oversold is an important part of cutting losses and taking profits. Open interest is especially useful in this respect, providing one simple rule: As the number of outstanding contracts decreases, so do the odds of the prevailing trend extending its range. When rates of participation fall off significantly, a market is said to have “dried up.” In this scenario, trends slow, markets enter rotation, and reversals become more of a possibility.
Of course, as in all things trading, every rule has exceptions. Market participation often spikes unexpectedly, resulting in sudden trend continuation or full-blown market reversal. By being aware of the liquidity and activity levels present in a security, a trader is able to craft decisions based on probability rather than intuition alone.
Applying Open Interest
For even the most battle-tested market veterans, managing an active futures position can be a challenging task. Price often moves swiftly, leaving the trader little time to properly align risk and reward. Here are a few ways that traders use open interest to craft trade-related decisions on-the-fly:
|Down||Increasing||Hold Shorts/New Sells, Exit Longs|
|Down||Decreasing||Exit Shorts, Potential Reversal|
|Up||Increasing||Hold Longs/Possible Buys, Exit Shorts|
|Up||Decreasing||Exit Longs, Potential Reversal|
While liquidity is a powerful element of market behavior, it’s not the only factor dictating the ultimate success or failure of a given trading strategy. As with any facet of active trading, it’s best used in concert with other technicals/fundamentals, within the framework of a comprehensive trading plan.
Perhaps the most important thing to remember about liquidity is that it’s not always constant. Time of day, season, or macro-economic cycle are just a few inputs that influence a market’s level of activity. However, by understanding what liquidity is and how it’s measured, a trader is empowered to make strong decisions while avoiding the hazards posed by “dry” markets.
It’s said that those “in the know” often prosper. A visit to the online educational suite at Daniels Trading is a great way to make sure your trading IQ keeps pace with the competition.