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Open Interest: The number of outstanding contracts in a certain listed derivative
While many traders follow action in the S&P 500 E-minis as a proxy for the overall market, only a handful of these traders track and interpret open interest figures. By knowing how many futures contracts are being created or closed out on a daily basis allows a trader gain a second layer of understanding to compliment his or her analysis of price action. To begin our discussion, lets discuss how contracts are created and how they are closed. Take a look at the matrix below:
Figure 1.1:
|
Sell Long
|
0 |
-1 |
|
Sell Short
|
+1 |
0
|
| |
Buy Long |
Cover
|
In the matrix we can see four separate scenarios; one in which a contract is created, one in which a contract is closed, and two neutral events. First, a contract is created when Person A buys one contract from Person B who then becomes short one contract (bottom left quadrant). If person A sells his or her contract to Person C, it is simply a transfer of ownership and no contracts are created or closed (top left quadrant). Similarly, if Person B covers his contract and Person D shorts the same contract, there is no change in open interest (bottom right quadrant). Finally, lets return to our original example where Person A is long one contract and Person B is short one contract. If Person A sells his contract to Person B, thereby allowing him to cover, the contract is closed and open interest decreases by 1.
Rising vs. Falling Markets
On the surface, a change in open interest seems like a market neutral event (one individual is getting long while another is getting short); however, the indicator takes on significance in the context of market direction. First, let’s examine the implications of open interest figures in a rising market. Refer back to Figure 1.1; this scenario favors the bottom left quadrant. While it is true that every contract bought is met with an equal number of short contracts, the fact that the market is moving higher suggests that the longs are price takers and the shorts are price makers. This implies that traders are aggressively getting long and willing to lift offers. On the other hand, if the market is rising as open interest is falling, it implies that the shorts are being squeezed and are aggressively covering their positions.
The same exact logic applies to analyzing open interest in a declining market. If open interest is negative in tandem with the market, it favors the upper right hand quadrant of figure 1.1. Traders holding long futures are selling their positions more aggressively (by hitting bids) than short traders are covering their positions. In this scenario, the shorts are the price makers and the longs are price takers. Conversely, if open interest rises in a declining market, it suggests that traders are aggressively shorting futures contracts.
Interpreting the Figures
Now that we know the implications of positive and negative open interest figures, let’s discuss how the figures can be interpreted. In his classic book Technical Analysis for the Financial Markets, John Murphy provides a description of open interest that provides a basic framework for their interpretation. First, when open interest is rising in a rising market, it implies there are “real” buyers, individuals who are seeking to build a long position and will lift an offer to do so. Murphy goes on to explain that this pattern is most effective in the early and middle stages of a market cycle. On the other hand, if open interest is negative as the market is rising, the primary upward force is provided by short covering; traders who are panicking out of a short position thereby driving the market higher. While a short covering rally may provide a temporary boost to the market, in the long term, “real” buyers will provide sustenance to a rising market and perpetuate the trend.
The interpretation of open interest figures in a downward trending market follows a separate pattern. If open interest is rising as the market sells off, it is a bearish indicator; traders are shorting more contracts as the market trends lower. This is comparable to the “real” buying in the first example. Conversely, if open interest is negative in a downward trending market it implies that longs are puking out of their positions creating the opposite effect of a short covering rally.
While Murphy’s interpretation of open interest figures is commonly accepted, there are additional ways to dissect the figures that lead to slightly different conclusions. First, we must make the assumption that S&P 500 futures contracts are the security of choice for hedging a long equity portfolio. Given this fact, let’s explore what happens when open interest spikes higher when the market moves in the direction of the prevailing trend. Using empirical data, this action may signal a reversal in trend. Assume the market is 15% off its highs and we witness a 2% down day with a spike in open interest. This may signal that managers who are holding long equity portfolios are finally capitulating and hedging those positions by shorting futures. Similarly, if the market has been trending higher and open interest is sharply positive it indicates that managers are desperately trying to get longer to chase returns.
Now let’s discuss when open interest is negative. In a long term uptrend, one would expect a down day to see a modest downtick in open interest as a few weak hands blow out of their long positions. Similarly, when the market is trending lower one would expect negative open interest figures turn negative as managers cover their hedge for fear of missing the next move up.
An Historical Perspective
In order to fully understand the implications of open interest figures, let’s take a look back at open interest figures during various inflection points in the 2010-2011 market. Back in early 2010, the market sold off 9% over the course of there weeks to reach its February lows. In the final week of this sell off, open interest figures spiked to extremely high levels. This suggests that traders with long equity portfolios aggressively rushed into hedge during this third week as the losses became too great to bear. As we emerged from the final days of that sell off, open interest figures reversed course and turned modestly negative as the people who shorted in week three believed the market was actually going to turn higher and quickly covered their shorts at a loss. As the market continued to rise in the period between February and April, we saw modestly higher open interest on up days and slightly negative figures on down days; managers felt comfortable getting long on the way up as a few weak hands got shaken out and sold on down days.
Fast forward to the early July and late August lows; once again open interest spiked preceding the market bottom, suggesting that longs were no longer able to take the pain and hedged up their portfolios. As the market began to turn higher, once again open interest figures turned slightly negative as traders covered their short futures positions. Then, an historical run in the market occurred. Between early September 2010 and late February 2011, the market drove up over 20% signaling one of the strongest bull runs in 15 years. During this time period, the majority of positive days were met with modestly positive and the majority of negative days saw slightly negative figures; a normal pattern. Then, January 28th happened. The market pulled back 2.2% and open interest spiked to extreme levels. Normally, during a day such as this one would expect the numbers to be slightly negative to flat. The fact that open interest saw such an enormous rally indicates that portfolio managers were rushing into the market to aggressively hedge their books. Given the historical nature of this rally, the grandiose open interest figures during sell offs indicate a degree of fear amongst managers of a sharp, fast pullback in the market. This has created an environment of long, protracted grinds up and steep, violent sell offs.
Conclusion
Understanding open interest figures provides another layer of understanding to price action in the futures market. Open interest can be used to understand underlying market mentality which in turn can be a predictive indicator of longer term momentum shifts in the market. Furthermore, these numbers become even more powerful when supplemented with other market indicators such as average TICK and expansion/contraction of the daily range. I encourage our members to keep track of open interest figures, which can be found of the CME’s webpage, and watch how the ebbs and flows of the market coincide with changes in open interest.
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