A contract has both a buyer and a seller, so the two market players combine to make one contract. The open-interest position that is reported each day represents the increase or decrease in the number of contracts for that day, and it is shown as a positive or negative number. An increase in open interest along with an increase in price is said to confirm an upward trend. Similarly, an increase in open interest along with a decrease in price confirms a downward trend. An increase or decrease in prices while open interest remains flat or declining may indicate a possible trend reversal.
Rules of Open Interest
If prices are rising and open interest is increasing at a rate faster than its five-year seasonal average, this is a bullish sign. More participants are entering the market, involving additional buying, and any purchases are generally aggressive in nature.
If the open-interest numbers flatten following a rising trend in both price and open interest, take this as a warning sign of an impending top.
High open interest at market tops is a bearish signal if the price drop is sudden, since this will force many 'weak' longs to liquidate. Occasionally, such conditions set off a self-feeding, downward spiral.
An unusually high or record open interest in a bull market is a danger signal. When a rising trend of open interest begins to reverse, expect a bear trend to get underway.
A breakout from a trading range will be much stronger if open interest rises during the consolidation. This is because many traders will be caught on the wrong side of the market when the breakout finally takes place. When the price moves out of the trading range, these traders are forced to abandon their positions. It is possible to take this rule one step further and say the greater the rise in open interest during the consolidation, the greater the potential for the subsequent move.
Rising prices and a decline in open interest at a rate greater than the seasonal norm is bearish. This market condition develops because short covering and not fundamental demand is fueling the rising price trend. In these circumstances money is flowing out of the market. Consequently, when the short covering has run its course, prices will decline.
If prices are declining and the open interest rises more than the seasonal average, this indicates that new short positions are being opened. As long as this process continues it is a bearish factor, but once the shorts begin to cover it turns bullish.
A decline in both price and open interest indicates liquidation by discouraged traders with long positions. As long as this trend continues, it is a bearish sign. Once open interest stabilizes at a low level, the liquidation is over and prices are then in a position to rally again.
Let's summarize these with an easy-to-read chart:
So, price action increasing in an uptrend and open interest on the rise are interpreted as new money coming into the market (reflecting new buyers) and 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 and is considered bearish.
If prices are in a downtrend and open interest is on the rise, chartists know that new money is coming into the market, showing aggressive new short selling. This scenario will prove out a continuation of a downtrend and a bearish condition. Lastly, if the total open interest is falling off and prices are declining, the price decline is being caused by disgruntled long position holders being forced to liquidate their positions. Technicians view this scenario as a strong position technically because the downtrend will end as all the sellers have sold their positions. The following chart therefore emerges:
When open interest is high at a market top and the price falls off dramatically, this scenario should be considered bearish. In other terms, this means that all of the long position holders that bought near the top of the market are now in a loss position, and their panic to sell keeps the price action under pressure.