Strength or Weakness?

In the same way as we did when looking at volume, we can set out some general rules indicating what open interest means about the strength or weakness of the market. For instance, if prices are rising in an uptrend and total open interest is increasing, then the market is looking strong. Because the interest is up, new money is flowing into the market coming from people who have not been involved, or who have decided to increase their stake, and this is a positive sign.

On the other hand, if you have the same rising market, but a declining open interest, it shows signs of weakness. This is because the rally in prices is fuelled mainly by people covering their short positions, in other words holders of losing short positions are liquidating them. We can tell this because money is leaving the market with the decline in open interest. Once everybody who wants to has covered their shorts, the uptrend caused by this action will probably weaken.

Consider the opposite case. If you have a downtrend in the price but the open interest is up, that again suggests weakness in price, which will continue to show as a bearish trend. New money is coming to the market, but it is not in favour of the financial security, but betting against it. From a technical point of view what is happening is that new contracts are being opened by short sellers, and this market sympathy will continue to drive the price down.

Finally, if both the open interest and the price are trending downwards, this is interpreted as strengthening the technical position. The reason is that the declining price is caused by traders liquidating their losing long positions, reducing the number of open contracts. As with the case above, where traders liquidated their shorts, we expect the market to turn when everybody who wants to has sold off.

These four situations can be summarized as follows: –

• If open interest is rising in an uptrend, the outlook is bullish.
• If open interest is falling in a downtrend, the outlook is bullish.
• If open interest is rising in a downtrend, the outlook is bearish.
• if open interest is falling in an uptrend, the outlook is bearish.

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