Using Open Interest to Find Bull/Bear Signals

Traders often use open interest as 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. You can gauge the strength of the market by using volume in conjunction with open interest.

Here, we'll look at the importance of the relationship between volume and open interest in confirming trends and their impending changes.

Factors Used in Open Interest Bull/Bear Signals

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. Volume represents a measure of intensity or pressure behind a price trend.

Open interest is the number of trades not settled at a given moment for a specific asset. An increase in open interest suggests that additional or new money is flooding into the market because more traders have opened positions for the day than closed them. In contrast, a decrease in open interest indicates that money is flowing out of the market because more positions close than open.

Price action is the trend prices have taken for the period being evaluated. Price action is related to volume, and both of these factors are related to open interest because volume and price follow each other and create interest in opening or closing positions.

So, many traders combine price action, volume, and open interest to create bullish or bearish market signals.

How to Use Bull/Bear Open Interest Signals

The basic rules for price action, volume, and open interest are demonstrated in the following table:

Price action increasing during an uptrend and rising open interest are interpreted as new money coming into the market. That reflects new buying, which is considered bullish. If the price action is rising and the open interest and volume are declining, short sellers covering their positions are causing the price rally. Therefore, money is leaving the marketplace. Traders view this as a bearish sign.

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

Lastly, if open interest and volume are falling and prices are declining, it is likely 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 closed their positions.

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.

Criticism of Open Interest Bull/Bear Signals

Other analysts interpret some of these signals quite differently, mainly 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 on the way up, the information doesn't benefit investors in deciding 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. The relative strength indicator 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.

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