Forex Walkthrough


Long Term - Open Interest

Market sentiment is the most important factor that drives the currency market, but assessing market sentiment is one aspect of trading that is often overlooked by traders. While there are quite a few ways of gauging what the majority of market participants are thinking or feeling about the market, in this article, we'll take a look at how to do this using interest analysis.

Open Interest in Forex

Open interest analysis is not uncommon among those who trade futures, but it is a different story for those who trade spot forex.
One of the most important points to note about the spot forex market is that information pertaining to open interest and volume is not available because transactions are carried out over-the-counter, and not through exchanges. As a result, there is no record of all the transactions that have taken place or are taking place in all the "back alleys". Without open interest and volume as vital indicators of the strength of spot price moves, the next best thing would be to examine the open interest data on currency futures. (For related reading, see Getting Started In Foreign Exchange Futures.)

Spot FX Vs. FX Futures
Open interest and volume data on currency futures allow you to gauge market sentiment in the currency futures market, which also influences, and is influenced by, the spot forex market. Currency futures are basically spot prices, which are adjusted by the forward swaps (derived by interest rate differentials) to arrive at a future delivery price. Unlike spot forex, which does not have a centralized exchange, currency futures are cleared at exchanges, such as the Chicago Mercantile Exchange (CME), which is the world's largest market for exchange-traded currency futures. Currency ffutures are generally based on standard contract sizes, with typical durations of three months. Spot forex, on the other hand, involves a two-day cash delivery transaction. (To learn more, see Futures Fundamentals.)

One of the many differences between spot forex and currency futures lies in their quoting convention. In the currency futures market, currency futures are mostly quoted as the foreign currency directly against the U.S. dollar. For example, Swiss francs are quoted versus the U.S. dollar in futures (CHF/USD), unlike the USD/CHF notation in the spot forex market. Therefore, if the Swiss franc depreciates in value against the U.S. dollar, USD/CHF will rise, and the Swiss franc futures will decline. On the other hand, EUR/USD in spot forex is quoted in the same manner as euro futures, so if the euro appreciates in value, euro futures will rise as the EUR/USD goes up. (For more insight, see The Forex Market.)

The spot and futures prices of a currency (not currency pair) tend to move in tandem; when either the spot or futures price of a currency rises, the other also tends to rise, and when either falls, the other also tends to fall. For example, if the GBP futures price goes up, spot GBP/USD goes up (because GBP gains in strength). However, if the CHF futures price goes up, spot USD/CHF goes down (because CHF gains in strength), as both the spot and futures prices of CHF move in tandem.

What Is Open Interest?
Many people tend to get open interest mixed up with volume. Open interest refers to the total number of contracts entered into, but not yet offset, by a transaction or delivery. In other words, these contracts are still outstanding or "open". Open interest that is held by a trader can be referred to as that trader's position. When a new buyer wants to establish a new long position and buys a contract, and the seller on the opposite side is also opening a new short position, the open interest is increased by one contract.

It is important to note that if this new buyer buys from another old buyer who intends to sell, the open interest does not increase because no new contracts have been created. Open interest is reduced when traders offset their positions. If you add up all the long open interest, you will find that the aggregate number is equal to all of the short open interest. This reflects the fact that for every buyer, there is a seller on the opposite side of transaction.

Relationship Between Open Interest and Price Trend
Overall, open interest tends to increase when new money is poured into the market, meaning that speculators are betting more aggressively on the current market direction. Thus, an increase in total open interest is generally supportive of the current trend, and tends to point to a continuation of the trend, unless sentiment changes based on an influx of new information.

Conversely, overall open interest tends to decrease when speculators are pulling money out of the market, showing a change in sentiment, especially if open interest has been rising before.

In a steady uptrend or downtrend, open interest should (ideally) increase. This implies that longs are in control during an uptrend, or shorts are dominating in a downtrend. Decreasing open interest serves as a potential warning sign that the current price trend may be lacking real power, as no significant amount of money has entered the market.

Therefore, as a general rule of thumb, rising open interest should point to a continuation of the current price move, whether in an uptrend or downtrend. Declining or flat open interest signals that the trend is waning and is probably near its end. (To read more, check out Discovering Open Interest - Part 1 and Part 2.)

Putting It Together
Take, for example, the period between October and November 2004, when the euro futures (in candlesticks) embarked on a trend of higher highs and higher lows (as seen in Figure 1 below). As depicted in the upper chart window, there were several opportunities to go long on the euro, whether by trading breakouts of resistance levels or by trading bounces off the daily up trendline. You can see in the lower window that open interest of euro futures had been increasing gradually as the euro went up against the U.S. dollar. Note that the price movements of spot EUR/USD (seen as blue line) moved in tandem with euro futures (candlesticks). In this case, the rising open interest accompanied the existing medium-term trend, hence, it would have given you a signal that the trend is backed by new money.

Figure 1: composite daily chart of euro futures (candlesticks) overlay with spot EUR/USD prices (dark blue line).

However, sometimes you may get a strong clue that a trend is of a suspect nature. This clue usually comes in the form of falling open interest that accompanies a trend, whether it is an uptrend or downtrend. In Figure 2, you can see that the pound sterling futures (in candlesticks) trended down between September and October 2006 (as did spot GBP/USD, seen as dark blue line). During this same period, open interest fell, signifying that people were not shorting more contracts; therefore, the overall sentiment is not bearish at all. The trend then promptly reversed, and open interest started increasing.

Figure 2: A composite daily chart of sterling futures (candlesticks) overlay with spot GBP/USD prices (dark blue line).

Whether you are trading currency futures or spot forex, you can make use of the futures open interest to gauge the overall market sentiment. Open interest analysis can help you confirm the strength or weakness of a current trend and also to confirm your trade.

COT Report
Related Articles
  1. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  2. Taxes

    Here's How to Deduct Your Stock Losses From Your Tax Bill

    Learn the proper procedure for deducting stock investing losses, and get some tips on how to strategically take losses to lower your income tax bill.
  3. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  4. Chart Advisor

    4 European Stocks to Consider Buying

    European companies, listed on US exchanges, that are providing buying opportunities right now.
  5. Stock Analysis

    3 Solar Stocks to Add to Your Portfolio

    Understand the growth and challenges of the renewable energy market and its success in 2015. Learn about the top three energy stocks to add to a portfolio.
  6. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  7. Investing

    Have Commodities Bottomed?

    Commodity prices have been heading lower for more than four years, being the worst performing asset class of 2015 with more losses in cyclical commodities.
  8. Chart Advisor

    ChartAdvisor for October 2 2015

    Weekly technical summary of the major U.S. indexes.
  9. Mutual Funds & ETFs

    Top Three Transportation ETFs

    These three transportation funds attract the majority of sector volume.
  10. Investing Basics

    Statistical Proof That Buy-and-Hold Investing Pays Off

    Learn about how the data suggests that the buy-and-hold investment strategy still works, even after the huge declines of the Great Recession.
  1. Qualitative Analysis

    Securities analysis that uses subjective judgment based on nonquantifiable ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based ...
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and ...
  4. Liquidity

    The degree to which an asset or security can be quickly bought ...
  5. Derivative

    A security with a price that is dependent upon or derived from ...
  6. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  1. Can working capital be too high?

    A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
  2. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  3. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  4. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  5. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  6. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!