A new student to technical analysis can easily see that the volume represents a measure of intensity or pressure behind a price trend. According to some observers, greater volume implies that we can expect the existing trend to continue rather than reverse. Many technicians believe that volume precedes price. They think the end of an uptrend or a downtrend will show up in the volume before the price trend reverses on the bar chart.
Their rules for both volume and open interest are combined because of similarity.
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However, even supporters of this theory admit that there are exceptions to these rules. There are many conflicting technical signals and indicators, so it is essential to use the right ones for a given application. The basic rules for volume and open interest:. Price action increasing during an uptrend and open interest on the rise are interpreted as new money coming into the market. That reflects new buying, which is considered bullish. Now, if the price action is rising and the open interest is on the decline, short sellers covering their positions are causing the rally.
Money is, therefore, leaving the marketplace—this is taken as a bearish sign. If prices are in a downtrend and open interest is on the rise, some chartists believe that new money is coming into the market. They think this pattern shows aggressive new short selling. They believe this scenario will lead to a continuation of a downtrend and a bearish condition. Suppose the total open interest is falling off and prices are declining.
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This theory holds that the price decline is likely being caused by disgruntled long position holders being forced to liquidate their positions. Some technicians view this scenario as a strong position because they think the downtrend will end once all the sellers have sold their positions.
According to the theory, high open interest at a market top and a dramatic price fall off should be considered bearish. That means all bulls who bought near the top of the market are now in a loss position. Their panic to sell keeps the price action under pressure. Other analysts interpret some of these signals quite differently, mostly because they place less value on momentum. In particular, excessive short interest is seen by many as a bullish sign.
How to use Open Interest In Options Trading?
Short selling is generally unprofitable, particularly after a significant downward movement. However, naive price chasing often leads less informed speculators to short an asset after a decline. When the market rises, they have to cover. The typical result is a short squeeze followed by a fierce rally.
In general, momentum investors are not nearly as good at predicting trend reversals as their contrarian counterparts. While it is true that there is generally more buying and bullish price action all the way up, that does nothing to help investors decide when to sell. In fact, volume often increases before, during, and after major market tops. Some of the most respected indicators are based on contrarian views. RSI is another useful contrarian technical indicator.
How the Open Interest is formed?
There is no need to study a chart for rule-based signals. If you are a new technician trying to understand the basics, look at many different theories and indicators. What works for some assets and investment styles will not work for others. Look at stocks, bonds, gold, and other commodities and see if a specific indicator works for a particular application. Technical Analysis Basic Education. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. What is lacking in most educational programs offered to retail options traders is an understanding of the Professional Side of the market.
They are baffled when this happens because they believed that open interest told the direction the stock would take. ME10 Standard Course Edition. ME10 Premier Course Edition.
What is Open Interest? Definition of Open Interest, Open Interest Meaning - The Economic Times
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Options Course Edition. Market Corrections Edition. The mistake retail options traders make is to assume that the intent and purpose of an option trade by a professional is the same intent and purpose they have for the option contract. The Buy Side Institutions regularly buy and sell options contracts. Options trading by institutions is expected to grow exponentially over the next few years, creating more liquidity for the options marketplace due to new regulations and compliance requirements from the SEC and US government for all institutions, both large and small funds.
However, the Institutions are not necessarily buying or selling an option contract just for a short-term profit gain, as are retail options traders. Understanding Open Interest and what that means when the Giant Buy Side Institutions are trading options alters what Open Interest really means for near-term stock price movement. This is what separates the professional trader and the high success rate they enjoy from the retail trader, who typically has chronic losses with minimal profits and gains.
The retail trader will study Open Interest and may see that there is a huge number of puts for a large cap stock. The retail trader wrongly assumes that this means that everyone trading options at that time believes the stock is going to go down in price. However, a professional and former market maker, Catherine Clay, points out in her webinar presentation with TechniTrader available upon request that the huge number of puts comes from one transaction.
Thus, the professional goes and searches to find out what is going on and why the puts were purchased. The professional can quickly identify a giant lot buy order on her screen with her professional tools.
She sees that a giant lot buy order for the underlying stock occurred seconds before the large order for put options was placed. Thus, the puts were never intended to be a profitable trade, but are used simply as a cheap means of insuring against downside risk for a giant lot multi-million dollar stock buy transaction. The retail trader buys puts or sells calls or any variety of strategies, and the stock moves up with huge gains the next day as High Frequency Traders HFTs drive price up after discovering the giant lot Dark Pool buy order from the prior day.
What experience retail options traders need to realize and accept, if they are serious about becoming financially independent and as successful as the professional, is that oversimplification of Options Tools is a huge detriment. Sure, sometimes high put numbers indicate a stock decline, but confirmation is a necessity to avoid losses.
Even if you use a straddle, strangle, or other multi-leg option and net a small loss or even a flat exit, the cost of your time, trading fees, and other expenses result in a larger loss than you may be estimating.