Traders often use open interest is an indicator to confirm trends and trend reversals for both the futures and options markets. Open interest represents the total number of open contracts on a security. Here, we'll take a look at the importance of the relationship between volume and open interest in confirming trends and their impending changes.

Key Takeaways

  • Many technicians believe that volume precedes price.
  • According to this theory, increasing volume and open interest indicate continued movement up or down.
  • If volume and open interest fall, the theory holds that the momentum behind the movement is slowing and the direction of prices will soon reverse.
  • Contrarian analysts interpret some of these signals quite differently, mostly because they place much less value on momentum.
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Volume

Volume and Open Interest

Volume, which is often used in conjunction with open interest, represents the total number of shares or contracts that have changed hands in a one-day trading session. The greater the amount of trading during a market session, the higher the trading volume. A new student to technical analysis can easily see that the volume represents a measure of intensity or pressure behind a price trend. According to some observers, greater volume implies that we can expect the existing trend to continue rather than reverse.

Many technicians believe that volume precedes price. They think the end of an uptrend or a downtrend will show up in the volume before the price trend reverses on the bar chart. Their rules for both volume and open interest are combined because of similarity. However, even supporters of this theory admit that there are exceptions to these rules.

There are many conflicting technical signals and indicators, so it is essential to use the right ones for a given application.

General Rules for Volume and Open Interest

The basic rules for volume and open interest:

Figure 1: General rules for volume and open interest

Price action increasing during an uptrend and open interest on the rise are interpreted as new money coming into the market. That reflects new buying, which is considered bullish. Now, if the price action is rising and the open interest is on the decline, short sellers covering their positions are causing the rally. Money is, therefore, leaving the marketplaceā€”this is taken as a bearish sign.

If prices are in a downtrend and open interest is on the rise, some chartists believe that new money is coming into the market. They think this pattern shows aggressive new short selling. They believe this scenario will lead to a continuation of a downtrend and a bearish condition.

Suppose the total open interest is falling off and prices are declining. This theory holds that the price decline is likely being caused by disgruntled long position holders being forced to liquidate their positions. Some technicians view this scenario as a strong position because they think the downtrend will end once all the sellers have sold their positions.

Figure 2: Bullish and bearish signs according to open interest

According to the theory, high open interest at a market top and a dramatic price fall off should be considered bearish. That means all bulls who bought near the top of the market are now in a loss position. Their panic to sell keeps the price action under pressure.

Contrarian Criticism

Other analysts interpret some of these signals quite differently, mostly because they place less value on momentum. In particular, excessive short interest is seen by many as a bullish sign. Short selling is generally unprofitable, particularly after a significant downward movement. However, naive price chasing often leads less informed speculators to short an asset after a decline. When the market rises, they have to cover. The typical result is a short squeeze followed by a fierce rally.

In general, momentum investors are not nearly as good at predicting trend reversals as their contrarian counterparts. While it is true that there is generally more buying and bullish price action all the way up, that does nothing to help investors decide when to sell. In fact, volume often increases before, during, and after major market tops.

Some of the most respected indicators are based on contrarian views. The most relevant signal here may be the put/call ratio, which has a good record of predicting reversals. RSI is another useful contrarian technical indicator.

The Bottom Line

There is no need to study a chart for rule-based signals. If you are a new technician trying to understand the basics, look at many different theories and indicators. What works for some assets and investment styles will not work for others. Look at stocks, bonds, gold, and other commodities and see if a specific indicator works for a particular application.