Long-term Trading Strategy with Open Interest

Open interest in the futures market is the number of contracts outstanding and it’s part of the COT Report (Commitment of Traders). It’s important to note that the open interest only refers to the number of futures contracts held overnight. In this regard, it’s going to exclude all day-trading activity. The open interest is created when buyers and sellers make contracts. So,  if I take a long position and you take a short position we created a contract, we created a commitment in the marketplace.

The open interest is not a real-time number as it’s only updated at the close of each business day. The open interest is not a cumulative type of number.  It’s how many contracts are open in the market at that moment in time.

Understanding Open Interest

Most traders are very aware of things such as volume and how volume works in order to sustain trends, but they are not quite as aware as to what’s called open interest. When we’re dealing with derivative contracts like CFDs, unlike shares which have a set number of stocks that are issued by a company, open interest can actually fluctuate and change.

open-interest-introductionWhen someone sells a contract they sell to a buyer. If you’re that buyer and you don’t have a position in this future contract whatsoever you can buy that contract from several different people that can actually be a new seller. That means this contract didn’t exist prior to this transaction occurring. What would happen is that this seller creates a new contract and sells it to you and this means that volume will go up by 1 contract and at the same time open interest will rise by 1 contract as this is the total number of contracts actually being traded at that moment.

open-interest-unchanged

If you buy a new contract from someone who already owns a futures contract which is deciding to exit their position for whatever reason, then what is really happening is that they are simply transferring that ownership to you in which case the volume will still rise by 1 contract, however, open interest will not change because we haven’t created a new contract. We have simply transferred ownership of a current contract to someone else.

open-interest-decreased

If you’re looking to close out a previous contract from someone who already owns a futures contract it means that both of the market participants are closing their position and open interest decreases by 1 contract.

How to Use The Open Interest?

The open interest should be used in the same manner as any other technical, seasonal or fundamental analytical theory. This isn’t the fail-safe answer to trading but it’s just another tool in your trading arsenal. When used in conjunction with other timing indicators and sentiment measures, this might improve the overall odds of success. It’s important to realize that open interest data is relative which really means absolutely nothing unless you know what the open interest looks like historically.

Understanding open interest is crucial when looking at trends and whether or not the trend is likely to continue. Lets’ suppose we’re in a trend, either bullish or bearish than we have these four different situations:

  1. If the volume and the open interest increases, the trend is more likely to continue as there is more interest from the market participants in that trend.
  2. If the volume increases but the open interest decreased, this is actually showing us that the market participants are existing from their contracts and therefore the trend might actually reverse.
  3. If the volume increases and the open interest it is still increasing we might also see a trend reversal because there are fewer and fewer people that are actually transacting which can be a sign of the bigger trend being in trouble.
  4. If both volume and open interest decreases, we’re having an exodus from these contracts and it’s the most powerful sign of a trend reversal.

Trade Example

open-interest-trade-example

In the above figure, we have the Canadian Dollar futures contracts and some short trading opportunities are highlighted. We can note two instances where both volume and open interest experienced a dramatic drop, signaling we have an exodus of shorts coming in the market and that the long-term trend is bearish. In this case, the right trading strategy would be to sell every rally.