The rules for interpreting open interest changes are similar to those for volume, but require additional explanation.1. With prices advancing in an uptrend and total open inter­est increasing, new money is flowing into the market reflec2.If, however, prices are rising and open interest declines, the rally is being caused primarily by short covering (holders of los­ing short positions being forced to cover those positions). Money is leaving rather than entering the market. This action is considered bearish because the uptrend will probably run out of steam once the necessary short covering has been completed. (See Figure 7.10.)
3.With prices in a downtrend and open interest rising, the technician knows that new money is flowing into the market, reflecting aggressive new short selling. This action increases the odds that the downtrend will continue and is consid­ered bearish. (See Figure 7.11.)
4. If, however, total open interest is declining along with declining prices, the price decline is being caused by discour‑ting aggressive new buying, and is considered bullish.
aged or losing longs being forced to liquidate their positions.
This action is believed to indicate a strengthening technical situation because the downtrend will probably end once open interest has declined sufficiently to show that most losing longs have completed their selling.
Let's summarize these four points:
1. Rising open interest in an uptrend is bullish.
2. Declining open interest in an uptrend is bearish.
3. Rising open interest in a downtrend is bearish.Declining open interest in a downtrend is bullish.
Other Situations Where Open Interest Is Important
In addition to the preceding tendencies, there are other market situations where a study of open interest can prove useful.
1. Toward the end of major market moves, where open interest has been increasing throughout the price trend, a leveling off or decline in open interest is often an early warning of a change in trend.
2. A high open interest figure at market tops can be considered bearish if the price drop is very sudden. This means that all of the new longs established near the end of the uptrend now have los­ing positions. Their forced liquidation will keep prices under pres­sure until the open interest has declined sufficiently. As an exam‑
ple, let's assume that an uptrend has been in effect for some time. Over the past month, open interest has increased noticeably. Remember that every new open interest contract has one new long and one new short. Suddenly, prices begin to drop sharply and fall below the lowest price set over the past month. Every sin­gle new long established during that month now has a loss.
The forced liquidation of those longs keeps prices under pressure until they have all been liquidated. Worse still, their forced selling often begins to feed on itself and, as prices are pushed even lower, causes additional margin selling by other longs and intensi­fies the new price decline. As a corollary to the preceding point, an unusually high open interest in a bull market is a danger signal.
3. If open interest builds up noticeably during a sideways con­solidation or a horizontal trading range, the ensuing price move inten­sifies once the breakout occurs. This only stands to reason. The mar­ket is in a period of indecision. No one is sure which direction the trend breakout will take. The increase in open interest, however, tells us that a lot of traders are taking positions in anticipation of the breakout. Once that breakout does occur, a lot of traders are going to be caught on the wrong side of the market.
Let's assume we've had a three month trading range and that the open interest has jumped by 10,000 contracts. This means that 10,000 new long positions and 10,000 new short posi­tions have been taken. Prices then break out on the upside and new three month highs are established. Because prices are trading at the highest point in three months, every single short position (all 10,000 of them) initiated during the previous three months now shows a loss. The scramble to cover those losing shorts nat­urally causes additional upside pressure on prices, producing even more panic. Prices remain strong until all or most of those 10,000 short positions have been offset by buying into the market strength. If the breakout had been to the downside, then it would have been the longs doing the scrambling.
The early stage of any new trend immediately following a breakout is usually fueled by forced liquidation by those caught on the wrong side of the market. The more traders caught on the wrong side (manifested in the high open interest), the more severe the response to a sudden adverse market move. On a more
positive note, the new trend is further aided by those on the right side of the market whose judgment has been vindicated, and who are now using accumulated paper profits to finance additional positions. It can be seen why the greater the increase in open interest during a trading range (or any price formation for that matter), the greater the potential for the subsequent price move.
4. Increasing open interest at the completion of a price pattern is viewed as added confirmation of a reliable trend signal. The break­ing of the neckline, for example, of a head and shoulders bottom is more convincing if the breakout occurs on increasing open inter­est along with the heavier volume. The analyst has to be careful here. Because the impetus following the initial trend signal is often caused by those on the wrong side of the market, sometimes the open interest dips slightly at the beginning of a new trend. This ini­tial dip in the open interest can mislead the unwary chart reader, and argues against focusing too much attention on the open interest changes over the very short term.