Open interest

In the case of futures charts, open interest takes the place of volume. Before discussing open interest on a chart, an explanation of exactly how it's determined and what it means is in order.

Put simply, open interest is the number of outstanding futures contracts. When a buyer and a seller involved in a futures contract initiate new positions, the open interest increases by one contract.

When you trade a futures contract, whether you're buying or selling, you're also either opening or closing a position. If you have no position, and you buy a futures contract, that's an opening position. When you sell that contract, you're closing the position. This can work for selling, too. If you have no position to begin with, and you sell a contract, you've opened a short position. When you buy this contract back or cover the short position, you're closing a position. For more information on shorting, see Chapter 2.

When both the buyer and seller in a trade are opening positions, the open interest of contracts increases. If only one of the participants in a trade is opening a new position, then the open interest doesn't change. Finally, if both participants in a trade are closing positions, the open interest decreases.

Figure 3-4 is a very simple example of how open interest increases and decreases. Here's how the days break down:

^ Day 1: Assuming that Day 1 on the chart is the first day the futures contract displayed trades, the beginning open interest is zero. For display purposes, two contracts trade, and both the buyer and seller are initiating new positions. These new positions create two new contracts.

^ Day 2: On Day 2, there are four more contracts initiated by both the buyer and seller, and the open interest increases to six contracts.

^ Day 3: On Day 3, things get a little trickier. Mr. A decides to sell his two contracts, and Ms. D decides to buy back (cover) two of the contracts she'd previously sold short. This reduced the open interest by two contracts.

^ Day 4: Finally, on Day 4, Mr. C sells his four contracts, but Mr. A buys them, so these open contracts are transferred, and no new contracts are created. The open interest doesn't change.

Figure 3-5 is a chart of soybean futures, which expire in November 2007. I actively trade the soybean futures market, so this chart is near and dear to my heart. The open interest appears in the same area on the chart as the volume did on the chart of Google in Figure 3-3. Notice the increase in open interest during the life of this contract moving from left to right on the chart. This increase is due to the time approaching expiration, but also due to the fact that the summer of 2007 was a volatile market (although basically all summers are volatile in the wild world of beans).

Figure 3-4:

A simple example of — how open Day 1

Open Interest

Action

Open Interest interest is Day 2 created. DaY 3 Day 4

A buys 2 contracts and B sell 2 contracts C buys 4 contracts and D sells 4 contracts

A sells his 2 contracts and D covers 2 contracts C sells 4 contracts and A buys 4 contracts

Figure 3-5:

A candlestick chart of the soybean market futures with open interest.

Figure 3-5:

A candlestick chart of the soybean market futures with open interest.

As beans topped out, so did open interest. That would've sparked some traders to sell beans, because there were fewer new participants coming into the market at higher prices. The same would be true if beans had been dropping dramatically. Either way, a reversal of open interest along with a reversal of certain candlestick patterns (more on those in Parts II and III of this book) are two items worth looking out for when considering a trade.

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