If you ever looked at commodity futures or options data, you certainly have seen a figure called open interest. Open interest is the number of derivative contracts outstanding. As you can understand from this definition (but I want to repeat anyway to make it clear), open interest doesn’t count the settled contracts; it only includes futures or option contracts that are active at the moment. This number reflects an accurate view of market activity; by analyzing it one can see how the capital flow to the markets is changing.
Open interest (OI) is an important number to look at, especially to spot trend continuations and reversals. However, since it is just the number of outstanding contracts which doesn’t include the price, we always have to analyze in the context of price action. An increase in open interest implies traders’ willingness to hold or even increase their positions. We can say that if OI rises, it is a momentum signal.
We can identify some rules for how OI can be used to predict trends or reversals.
1) If both the market and OI go up, this is a bullish signal. The buyers, who dominate the market, increase their positions; short positions are liquidated and new shorts enter the market.
2) If the market is in uptrend, but OI is decreasing, it predicts the reversal. The old longs take profit and overall bulls’ willingness to hold their positions falls.
3) Both the market and OI falling indicates a bullish bias. The smart shorts take profit; the new shorts who replace the old ones are not as strong (or smart) as the previous ones. Decreasing OI means that old longs have been liquidated and replaced by the new ones which are not weakened as the old ones.
4) If price is falling but OI is going up, it predicts the continuation of the downtrend. The smart old bulls take profit and get out of the market and are replaced by new bulls who are not as strong or smart as the old ones. Falling OI implies that the shorts also leave the market by capitulating. But they are replaced by stronger bears.
