Open interest can help futures traders understand whether the market is gathering strength or losing momentum.
Wondering how? Have a look at the following scenarios and you could get in the right way of reading the open interest.
Here are the potential scenarios in markets and what they suggest.
Fresh Longs:
If prices are rising and open interest is increasing at an aggressive rate more than the average daily change, this is a bullish sign. More traders are entering the market, involving fresh buying, and also it indicates that longs are aggressive in nature.
Losing Momentum:
If the open interest numbers flatten i.e. have minimal changes following a rising trend in both price and open interest, this is a sign that a top is near because of exhaustion in participation which is indicated by minimal changes in OI.
Too high to handle:
Heavy open interest at market highs is a bearish signal because if there is a sudden price drop this will force many late longs to liquidate and thereby creates fear among others and the start of a downward spiral. This is the scenario to look out for when market has made new highs and is at extreme prices usually euphoria.
Accumulation for Breakout/ Distribution before Breakdown:
A breakout/breakdown from a trading range will be much stronger if accompanied by good open interest addition during the consolidation. This usually indicates the size of accumulation during that consolidation and the strength of the breakout/breakdown can be measured by the size of addition in OI.We can take a call that the greater the rise in open interest during the consolidation, the greater the potential for the subsequent up or down move.
Shorts booking profit > Pullback in downtrend:
Rising prices and a decline in open interest at a rate greater than the daily average change indicates temporary pullback in a downtrend. This market condition develops because short covering, not the real demand but fear, is fueling the rising price trend. In this case, money is flowing out of the market. Usually for any trend to be established OI addition is a prerequisite as that indicates fresh positions by participants. However these pullbacks can turn into a bigger trends if there are fresh participants joining after a partial pullback turning the tide the other way and this normally happens through a consolidation in between.
Fresh Shorts:
If prices are declining and the open interest rises more than the daily/weekly/monthly average change, 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.These kind of additions can be seen in cases where there is a downtrend in a higher time frame and a pullback in shorter time frame and Shorts get buildup on these pullbacks betting on the original trend.
Longs booking profit / fearing a fall:
A decline in both price and open interest indicates liquidation by lost interest from traders with long positions. This is usually a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are in a position to rally again when accompanied by a fresh long buildup.