Relationship between Volume and Open Interest in Trading Stock, Commodity and Currency Markets

relationship between volume and open interest in trading forex, mcx, nse, comex markets

Volume and Open Interest Relationship in Trading Commodity, Stock and Currency Market

The easiest method to demonstrate the generally acknowledged analysis between volume, open interest, and price action is to construct a table like the one below.

Price Volume Open Interest Market Analysis
Up Up Up Strong
Up Down Down Weak
Down Up Up Weak
Down Down Down Strong

As you can see from the above table, traditional open interest analysis includes four possibilities while in trading financial market like Commodity /Currency / Stock Segments.

  1. Prices are going up, and open interest is going up. This means that new money is flowing into the market and there is buying pressure (Do not incorrectly assume there are more buyers than sellers, because there are not. The price rise shows that the buyers are willing to pay higher prices and, of course, the sellers are prepared to cooperate.) This situation is considered bullish.
  2. Prices are going up, and open interest is declining. There are comparatively few new buyers, and money is leaving the market. The rally is most likely caused by shorts selling who are giving up and covering their positions, thereby exiting the market. This is often bullish for the short term, because the shorts will normally pay any price to get out, and because they cannot afford to stay in and accept further losses. This action is ultimately bearish. Without new money coming into the market, the rally will fail as soon as the short covering is finished. However, short covering gets to be self-enabling and can last longer than one might suspect. Expert says that the total open interest (meaning the open interest of all contracts combined) always declines five to eight days before the final top.

3      Prices are falling, and open interest is rising. New money is coming into the market, and there is selling pressure. This is considered bearish.

  1. Prices are falling, and open interest is falling. This is the opposite of situation 2. Now the short sellers are making money and can afford to stay in the market. Much of the price drop is caused by discouraged longs closing out their positions. There is little new money coming into the market. This is initially bearish, but the market is considered ripe for a rally once the discouraged long liquidation is finished. The short sellers are generally notorious for their lack of patience and are likely to start covering as soon as the downward momentum subsides.

While we see nothing incorrect about these analyses, we question their value. If your market opinion needs strengthening, the analysis may be useful as a method of confirmation. We don’t think that trading on open interest analysis will prove fruitful.

Having said that open interest changes do not appear to lead price changes, we must mention a significant observation about open interest that was pointed out to us many years ago. In a sideways or slightly downward market, a sudden drop in open interest is often followed by a market rally. The conventional perception is that the large market participants are lifting their hedges in anticipation of an expected rally. The feeling is that “insiders” know which way the markets are going and position themselves in front of the anticipated move.

The “insider” theory runs throughout volume and open interest studies. It is hard for us to believe that anyone ever actually “knows” which way any futures market is heading. In fact, contrary to popular perception, large commercials firms trade futures because they don’t know which way the markets are going, not because they do. If they or anyone knew much of anything with any certainty, the futures markets would be nonexistent in a matter of months. A more likely clarification for an open interest drop before a rally is a lack of confidence about market direction on the part of all traders. The shorts are not interested in the market, because of the low prices. The longs are not interested in a market that appears to be in an extended downtrend. Though, rallies often seem to begin with very negative sentiment in a market that is already at low levels. In a situation like this, a sentiment indicator likes “Bullish Consensus” by Hadady would probably be a better indicator than volume or open interest.

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