Hello and Welcome to the ditto educational series that will provide you with the skills you need to become a forex trader!
Today we will be discussing volume and open interest and how it affect the market. By measuring volume and open interest we can help to determine strength of trends and reversals. We began to discuss open interest in the lesson we did regarding the COT report if you have not seen this lesson I suggest you watch it first.
Open interest is an indicator often used by traders to confirm trends and market reversals for both forex futures and options markets. Open interest (also known as open contracts or open commitments) refers to the total number of outstanding contracts that have not been settled
For each buyer of a futures contract there must be a seller. From the time the buyer or seller opens the contract until the counter-party closes it, that contract is considered ‘open’.
Let’s now take a look at the important factors you must know between the relationship of volume and open interest so that you may confirm trends or foresee their reversals.
Let’s firstly note that volume in forex is not an especially reliable tool due to the fact that forex is a decentralised exchange. What I mean by this is you are only seeing the volume numbers from the current broker that you are using and not the figures for the entirety of the market. In order to gain a more clear picture of volume you would have to source your figures from multiple brokers so that you may gain greater perspective. Volume in forex is not completely useless and does occasionally give us clearer indications.
When used in conjunction with open interest, volume represents the total number of shares or contracts that have changed hands in a one days trading session in the commodities or options market. The greater the amount of trading during a market session, the higher the trading volume.
volume simply represents a measure of intensity or pressure behind a price trend. The greater the volume, the more we can expect the existing trend to continue rather than reverse.
Some traders believe that volume precedes price, the idea is that the loss of either upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend on the chart.
It can be said that open interest and volume sort of the same thing because of the similarities however there are always exceptions to this rule.
This illustration depicts the rules surrounding trend using volume and open interest data. Note that volume and open interest are always reflecting the same signal wether up or down.
Firstly if we see that price action is increasing in an uptrend and open interest on the rise is interpreted as new money coming into the market, this shows new buyers and is considered bullish.
Next if the price action is rising and the open interest is on the decline, this means sellers are covering their positions and are causing the rally. Money is leaving the marketplace and this is a bearish sign.
If prices are in a downtrend and open interest is on the rising, it means that new money is coming into the market, this shows aggressive new short selling. This scenario will likely cause a continuation of a downtrend and is bearish.
If the total open interest is declining and prices are declining, the price decline is likely being caused by buyers being forced to liquidate their positions. We can view this scenario as a strong position because the downtrend will end once all the sellers have sold their positions.
To summarise this information into a short usable formula we can say this:
Increasing open interest in a rising market is Bullish.
Declining open interest in a rising market is bearish.
Increasing open interest in a declining market is bearish.
Declining open interest in a declining market is bullish.
It personally helps me to remember this by considering double positives as bullish and positive negatives as bearish.
In other words increasing open interest in rising markets and declining open interest in a declining market are bullish. They both are going in the same direction. And when they are not it’s a bearish signal.
When using open interest to determine trends and reversals it is mostly important to remember these rules and the summary of these rules. We can apply these rules in conjunction with our other analysis. For instance we previously talked about net positioning in accordance with the COT report. If we combine net positioning in conjunction with open interest and daily candlestick analysis along prominent support and resistance levels we may be able to use these signals to predict significant reversals as well as trend continuations.
As always we are looking to build our knowledge of the forex market in order to develop our strategies surrounding identifying high probability trade set ups.
I hope you have enjoyed our educational session today ladies and gentlemen and now have a greater understanding of open interest. Please take your time to contemplate what you have learnt here today and remember that contemplation is the key to learning.