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Monday, December 24, 2007

The rules of Volume and Open Interest

Before performing an actual investment or trade, we should always consider the volume as well as the open interest of the market under question.

What is volume? Volume represents the amount of shares bought and sold in the case of a stock or commodity. What is Open Interest? Well, I personally only measure Open Interest when dealing with the Commodity Futures markets (Open Interest can also be used when examining stock options). When dealing with Open Interest in the context of Commodity Futures, Open Interest is the total number of contracts held for a Futures derivative, regardless of the contract month. Open Interest is different than volume. When looking at Volume, we do not know and we see the volume increase by 500, we do not know if that is 500 people who just entered, or exited a position. Open Interest tells us the net traders with actual positions.

So I started off saying that we should always consider the volume and open interest. How do we consider the volume of a stock before it's purchase? Well, I have a few rules when looking at Volume in relation to a stocks price. They are:

1) Rising prices, rising Volume / Falling prices, rising volume: The market is tending to confirm that this is a strong move.

2) Rising prices, falling Volume / Falling prices, falling volume: The market is telling us that the markets sentiment for rising prices may be waning, and that a reversal could soon take place in the trend and prices.

Thus, increasing volume confirms a move, where falling average volume warns us that a trend is weakening.

What about Open Interest for Commodity Futures? Here is a list of rules comprised by chartist Martin Pring in his book "Martin Pring on Market Momentum":
  1. If prices are rising and open interest is increasing at a rate faster than its five-year seasonal average, this is a bullish sign. More participants are entering the market, involving additional buying, and any purchases are generally aggressive in nature.
  2. If the open-interest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an impending top.
  3. High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many 'weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral.
  4. An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, expect a bear trend to get underway.
  5. A breakout from a trading range will be much stronger if open interest rises during the consolidation. This is because many traders will be caught on the wrong side of the market when the breakout finally takes place. When the price moves out of the trading range, these traders are forced to abandon their positions. It is possible to take this rule one step further and say the greater the rise in open interest during the consolidation, the greater the potential for the subsequent move.
  6. Rising prices and a decline in open interest at a rate greater than the seasonal norm is bearish. This market condition develops because short covering and not fundamental demand is fueling the rising price trend. In these circumstances money is flowing out of the market. Consequently, when the short covering has run its course, prices will decline.
  7. If prices are declining and the open interest rises more than the seasonal average, this indicates that new short positions are being opened. As long as this process continues it is a bearish factor, but once the shorts begin to cover it turns bullish.
  8. A decline in both price and open interest indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.
Larry Williams offers these insights, when examining Open Interest on a Commodity Future.

Commodity futures Open Interest is usually a reflection of what the Commerical Interests are doing inside the market. He estimates that 80% of the volume in most commodity markets is comprised of the commerical interests. Since these interests are extremely knowledgeable regarding the commodity in which they trade, it is vital to pay attention to these "Commercials". Since Commercials usually hedge their position, they are usually short selling in the market. With those points in mind, possibilities arise when a market enters a trading range (or channel)

  1. If open interest decreases, it is representative of less commerical activity and they are decreasing their short positions.
  2. If open interest increases, it is representative of more commercial activity and that they are increasing their short positions.
  3. Based on those two points, a 30% decrease in open interest can be a bullish indication and a 30% increase in open interest can be a bearish indication.
  4. Once again, it is imperative that a market be in a trading range for the above points.
Keep volume in mind, when looking over a stock price, and when looking at Commodity Futures, always be sure to include Open Interest in your calculations . . .

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Note: This is not an investment or trading recommendation. The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. I am not a licensed trading or investment adviser, or financial planner. But I do have 14 years of experience in trading and investing in these markets. The Challenge accounts are run for the education of other traders who should make their own decisions based off their own research, and tolerance for risk.

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