Understanding Open Interest

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From the Archives : Originally published August 21st, 2015
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Category : Gold University

Techniques for analysing and trading equities, looking at price and volume, can be applied to precious metal futures markets. Futures, however, introduce another data point – open interest – that has to be considered. With equities, the quantity of shares on issue is generally fixed and rarely changes. Therefore all buying is done from sellers who hold the shares.

With futures, the amount of contracts “on issue” or “open” changes daily, as a future is a contract to trade metal in the future and an exchange will create, or open, as many new contacts as people wish to enter into. If a seller of metal and buyer of metal want to enter into a contract, then a new contract will be opened. If an existing seller of a contact (a “short”) and an existing buyer of a contact (a “long”) want to exit their contract, then the contact will be closed.

Open interest represents the number of contacts created and in existence at a point in time. The table below summarises how open interest will change, depending upon who is buying and who is selling.

OImove

In the cases where open interest doesn’t change – that is, an existing long or short is being taken on by a new participant – there may be some information value in knowing who is closing and who is new/adding. This can be done by looking at the changes in the long and shorts held by the various categories on the Commitment of Traders report (material for another post).

It should be noted that a change in open interest indicates very little in and of itself as the opening or closing of a contact requires both a buyer (long) and seller (short). However, looking at changes in open interest in combination with changes in price may give an indication of market strength, as summarised in the table below (see Wikipedia).

PriceOITable

Note that increasing open interest can be associated with strong or weak markets. The logic is that if the price is rising and open interest is increasing, then buyers are having to increase their price to induce new sellers into the market. If the price is falling and open interest is decreasing, then longs are having to decrease their selling price to induce shorts to cover and exit the market. The table above can be represented graphically in the stylised chart below showing a rising and falling price with a rising and falling level of open interest.

PriceOI

While this chart demonstrates the highly theoretical nature of the price/open interest trading rule, there is some value in including open interest in your market analysis, as demonstrated in the chart below of the gold price during July 2015.

gc6month1

The light blue lines show the price falling while open interest was increasing, and indeed the market was weak, subsequently breaking through the $1140 support level. The light red lines show open interest decreasing while the price continued to fall and subsequently the market bottomed. Note that the chart also shows violations of the “rules”, so it is not fool proof.

The chart above also includes volume. While volume and open interest are related (they have a simple correlation of 0.81 over 40 years) they do not always move together, so one has to consider changes in both. Keep in mind that, everything else being the same, increases and decreases in open interest will both increase volume.

There are various technical indicators that combine price, volume and open interest, such as the Futures Volume Open Interest (FVOI) Indicator (a variation of On Balance Volume), which Sharelynx calculates and maintains charts for.

For those coming from equity investing, it is important when analysing futures data to remember that the precious metal markets are global and significant volumes are traded in the opaque over-the-counter (OTC) market. While Comex, and increasingly the SGE, have a significant impact on prices, they are not self-contained markets like those for the shares of a company.

Bullion banks and other traders arbitrage between futures markets, ETFs and the OTC market (otherwise prices would not stay in alignment) so action you see in public exchanges could be balanced by offsetting positions in other markets that are not visible to you. The relative wealth of data available on futures markets, and lack of data on OTC markets, can lead analysts to become myopic and forget that there may be other market forces from the OTC market impacting on the “visible” public exchange traded contracts.

 

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