Volume & Open Interest

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Using Volume & Open Interest in Futures & Options Markets

Technicians utilize a three dimensional approach to market analysis which includes a study of price, volume and open interest. Of these three, price is the most important. However, volume and open interest provide important secondary confirmation of the price action on a chart and often provide a lead indication of an impending change of trend. For beginning students of the market these two concepts tend to be somewhat confusing but are very important concepts to understand in- undertaking a thorough analysis of market action.

Volume represents the total amount of trading activity or contracts that have changed hands in a given commodity market, or other futures market for a single trading day. The greater the amount of trading during a market session the higher will be the trading volume. As mentioned earlier, a higher volume bar on the chart means that the trading activity was heavier for that day. Another way to look at this, is that the volume represents a measure of intensity or pressure behind a price trend. The greater the volume the more we can expect the existing trend to continue rather than reverse. Technicians believe that volume precedes price, meaning that the loss of upside price pressure in an uptrend or downside pressure in a downtrend will show up in the volume figures before presenting itself as a reversal in trend on the bar chart.

Open Interest is the total number of outstanding contracts that are held by market participants at the end of each day. Where volume measures the pressure or intensity behind a price trend, open interest measures the flow of money into the futures market. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract. Therefore, to determine the total open interest for any given market we need only to know the totals from one side or the other, buyers or sellers, not the sum of both.

Even though Open interest is utilised by Futures traders, we can extend it's use to the Spot Forex Market. The Spot Forex market doesn't record volume, so by using Open interest we can create a 'pseudo volume' indicator. More can be found on how to use open interest in Module 8.

Each trade completed on the floor of a futures exchange has an impact upon the level of open interest for that day. For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract. If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract. The third and final possibility is one old trader passing off his position to a new trader ( one old buyer sells to one new buyer). In this case the open interest will not change. By monitoring the changes in the open interest figures at the end of each trading day, some conclusions about the day's activity can be drawn. Increasing open interest means that new money is flowing into the marketplace. The result will be that the present trend ( up, down or sideways) will continue. Declining open interest means that the market is liquidating and implies that the prevailing price trend is coming to an end. A knowledge of open interest can prove useful toward the end of major market moves. A levelling off of steadily increasing open interest following a sustained price advance is often an early warning of the end to an uptrending or bull market.

The relationship between the prevailing price trend, volume, and open interest can be summarized by the following table.

PRICE Rising, VOLUME dropping and OPEN INTEREST dropping:	Market is running out of traders willing to open or hold an OPEN LONG. Traders are liquidating both loosing short positions and closing winning long positions. A higher probability the market is set to retrace in price lower at some point forward. Should prices be falling when this scenario develops, the market has a higher probability of a price rise at some point forward.
Price Rising, VOLUME rising and OPEN INTEREST rising:	Market is attracting larger numbers of traders willing to open positions from the long side and hold them. Traders are more confident that prices will continue to climb in favor of a working long. This scenario is a good clue that UPTREND is secure and that the trend may continue further for a period of time. Should this scenario develop while prices are falling, it is a good indication that DOWNTREND is secure and that the trend may continue for a period of time.
Price Rising, VOLUME dropping and OPEN INTEREST rising:	Market is attracting LATE buyers and EARLY shorts; market is vulnerable to a sharp correction but likely that that correction will be bought creating a buy point for UPTREND. If this scenario should develop while prices are dropping, it is a good indication that a sharp rally against DOWNTREND will develop creating a sell point for DOWNTREND.
Price Rising, VOLUME rising and OPEN INTEREST falling:	Market has a lot of traders initiating from both sides but larger traders may be liquidating into the higher prices. The market may be vulnerable to large price swings as shorter-timeframe traders attempt to trade from both sides of the market but liquidating before end-of-day. Often a signal of a market turn near-term or continued volatility. More common at significant tops (or bottoms). Should this scenario develop as prices are dropping, it is still the same quality of market action. Often this is a sign of a significant bottom.

Open Interest has Seasonal Tendancies

Here's a difference in open interest, as opposed to volume: Open interest has seasonal tendencies--higher at some times of the year and lower at some times of the year, in many markets. The seasonal average of the open interest is important in analyzing open interest figures. If prices are rising in an uptrend and total open interest is increasing more than its seasonal average (5-year average), new money is considered to be flowing into the market, indicating aggressive new buying, and that is bullish.

However, if prices are rising and open interest is falling by more than its seasonal average, the rally is being caused by the holders of losing short positions liquidating (short covering) and money is leaving the market. This is usually bearish, as the rally will likely fizzle.

The same holds true in a downtrend. Open interest increasing more than its seasonal average on the downmove means new aggressive sellers entering the market, and this is bearish. But if open interest is declining more than the seasonal average on the downmove, then it's likely holders of long positions are liquidating their losing trades (long liquidation), and that the downtrend may be near an end.

Here are two more rules for open interest:

1. Very high open interest at market tops can cause a steep and quick price downturn.

2. Open interest that is building up during a consolidation, or "basing" period, can strengthen the price breakout, when it happens.

It should be noted that a brief discussion of the basics of VOLUME and OPEN INTEREST cannot take the place of deeper study into market structure. V/OI is only one clue to potential market price action and no market condition is 100% definable from simply a brief understanding of the V/OI picture at any one point in time. V/OI is best used as confirmation tool when selecting price points that you personally expect the market to move away from creating a potential opportunity.

In closing, V/OI can be a powerful tool to help uncover good directional potential in any market you are trading. As someone serious about building a strong market presence you would be served best if you made a commitment to learning how this critical series of indicators can work. Next month, we will discuss the Commitments of Traders reports produced by the CFTC. Often misunderstood, when combined with a solid understanding of V/OI you have a good confirmation clue that something is changing across a broad range of market participants.

Introduction

Volume is simply the number of shares or contracts that trade over a given period of time. If you're looking at a chart, volume will be in a box below the price. After price itself, volume as an indicator is one of the most important pieces of information that a technical trader can look at. Large volume signifies there is significant interest in the market at a certain price and low volume signifies disinterest in buying or selling. With these fluctuating volumes we can track interest in the market. When volume picks up, this can be seen as a confirmation to trade and low volume generally signals to hold off for now.

Note. Forex Markets measure Sentiment in place of volume. Volume is hard to measure in an over the counter type market like FX. Instead of Volume, FX traders use The Commitment of Traders Report, measuring Open Interest We'll discuss this in Module 8.

In essence volume gauges the psychological mindset of the market. In the following paragraphs we'll look at the most important aspects this leading indicator and how it measures the trading mood. We'll see how volume affects volatility, confirms trends, signals reversals and retracements and how it can confirm chart patterns and the break-out. Volume can also affect crowd mentality. For more on the psychology of volume read Module 6. "Using Indicators to Read the Markets Psychological State"

Volume and Volatility

A market with low volume is more difficult to trade in as it becomes more volatile. When there are limited buyers and sellers, it only takes a few large trades to significantly change the supply/demand dynamic. In general the higher the volume, the higher the liquidity and the higher the liquidity then the lower the volatility in the market (The volatility is the size of price moves). Quite simply price movement in low volume is not a good indicator – we look for high volumes in technical analysis. When looking to compare and measure the change in volume traders need to measure it in relation to recent volume changes. Comparing today’s volume with that of 10 years ago is no good in determining how much more or less volume there is in a market.

Volume Confirming Trend

Volume can point to the health of a trend. A strong trend can be identified when volume increases as price moves the way of the trend and decreases when the price goes against the trend – i.e. in trend consolidation periods. Traders like to see volume increasing slowly as the trend continues. When the volume shows signs of decreasing on a trend it is a signal of trend weakness and may signal a trend reversal - this may coincide with an increase in volume on the price reversal. Price action and candlestick formations along with the interpretation of volume will help traders to determine reversals (Module 5).

In our below chart of S&P500 we can see a good example of volume increasing as the price moves with the trend (selling volume increases as the price decreases). You’ll see that on the 3rd Aug price price closed up a little against the down trend, but corresponding volume didn't increase significantly. This highlights that traders' conviction to the increase in price is muted. On another note this 3rd Aug price increase closes very close to it's open, again signifying indecision (see Module 5 on Price Action and Candlesticks for an explanation).

S&P 500 - Volume Confirming Trend

A trend based on high volume is likely to be short lived, but a trend based on moderate volume can last an extremely long time. The longest trends are probably driven by markets either going nowhere, changing moderately or even moving both up and down day after day, forming only a gradual trend, which is apparent when viewed in retrospect.

Volume Precedes Price and the Divergence

When volume tells a different story, it is a case of divergence, which refers to a contradiction between two different indicators. The simplest example of divergence is a clear upward price trend on declining volume. This divergence indicates a reversal is possible to the downside. In our below chart example of S&P 500 we can see this divergence at work. After a volume, down trend confirmation up to (A) we can see a divergence at work. Volume decreases from (A) to (B) as price increases. This divergence indicates uneasiness at this up trend in price by traders leading to a down trend from (B) to (3). This new down trend is now confirmed by increased volume.

S&P 500 - Volume Divergence

Another important idea in technical analysis is that price is preceded by volume. Volume is closely monitored by technicians and chartists to form ideas on upcoming trend reversals. If volume is starting to decrease in an uptrend, it is usually a sign that the upward run is about to end. In a way Volume is a leading indicator.

Volume to confirm Retracement or Reversal

Volume can help to confirm a temporary consolidation period within a trend (a retracement) or a trend reversal. If volumes are decreasing during a shift in trend it may mean a degree of profit taking prior to the trend continuing. We may even notice some buying interest in amongst the red bars in this retracement. However, if there are large blocks of selling volume then a full-blown reversal may be occurring. For more reading on retracement or reversal see module 4 Charting Tools.

As always, other factors need to be taken into consideration though – Chart patterns (e.g. double top may signify a reversal), trendlines, Fundamentals (i.e. changes) and price action (indecisive candles with long tops and bottoms may mean a retracement). Fibonacci retracements will help determine the scope of retracements (see the section on Fibonacci in Module 4 Charting Tools).

Volume, Chart Patterns & Break-Out

The other use of volume is to confirm chart patterns. Patterns such as head & shoulders, triangles, flags and other price patterns can be confirmed with volume, a process which we've explained in Module 2 "Chart Pattern Analysis". In most chart patterns, there are several pivotal points that are vital to what the chart is able to convey to chartists. Basically, if the volume is not there to confirm the pivotal moments of a chart pattern, the quality of the signal formed by the pattern is weakened.

Price action is the most important thing when interpreting volume. If a market is drifting sideways and breaks up or down with an increased movement in volume we can interpret this as increased interest in the price direction and assume this move will continue. If the breakout is coupled with lower volume then a false breakout can occur.

Dolan Media - Volume Confirming Break-Out

We've charted Dolan Media Grp above (Price and Volume Break-out), where the stock was charting in a slight down channel with slightly decreasing volume. Once the stock breaks the support on 22 Feb vol. increases on the sell off and the trend continues more vigorously. Something to keep in mind is sometimes you'll see volume pick up before a significant move – interest is building as traders anticipate a breakout.

To Sum Up

Volume is an extremely effective and important indicator and needs to be part of your trading set up. There are many volume indicators out there including On Balance Volume which we'll talk about next, but using volume on it's own allows traders to grasp the psychological state of the market and gives us an insight into where price is heading.

Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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