How to use Volume & Open Interest data as secondary indicators
Several chartists use the approach of price-action to predict the market movements. Some include volume too. However, most professional traders prefer using a multidimensional approach to market analysis. Price, Volume and Open Interest are the 3 dimensions which are carefully evaluated by these traders.
Open Interest
The total number of outstanding or unliquidated contracts at the end of the day is referred to as Open Interest. It represents the total number of outstanding longs or shorts in the market. Please note:It is not the summation of both
It is the number of contracts. Every contract needs 2 parties- a buyer and a seller. Hence, two parties agreeing on trade forms 1 contract. The open interest figures change every day. These changes such as increase or decrease in OI give the traders a clue as to how the market might behave next.
Few days back, during the end of the weekend, you might have heard that BTC rallied such violently after a short squeeze, where a lot of the short positions got liquidated. That is nothing but an aspect of the Open Interest.
With every trade that goes through, the OI might:
- Increase
- Decrease
- Stay unchanged
These changes are discussed in Table 1.
- If both the buyer and seller are initiating a new position, a new contract gets established.
- If buyer is initiating a new long position, while the seller liquidates an old long, the number of contract remains unchanged.
- Similarly, if the buyer liquidates an old position, while the seller initiates a new position, OI doesn’t change.
- If both traders are liquidating old positions, the OI goes down.
These changes in OI allow traders to predict the market momentum. Most traders use OI in conjunction with ‘Volume’ and ‘Price’. To understand, what these changes in OI, we take a look at table 2.
Presently, we have seen the markets entering a long term consolidation. A build-up in open interest during consolidation periods intensifies the ensuing breakout.
95% of traders follow the same technical indicators. Hence, the bigger players tend to use this fact to their advantage.
I would like to conclude the analysis by stating that: The markets can continue to be irrational as long it deems fit. No analysis is sacrosanct!
"Technical Analysis of the Financial Markets" by John J. Murphy talks about different aspects in detail. The above analysis has been researched and referenced from different parts of the book.