Whilst the new disaggregated format for the COT (commitment of traders) data is undoubtedly interesting in giving us a more detailed perspective into the trading activities of the major market players, some of the more traditional analysis of the data can still provide us with an excellent longer term view of the market.  One example is the  “open interest” category and how we can apply this data to the spot market.  For those of you new new to futures trading, open interest simply refers to the number of contracts in a particular market which are still open, in other words, yet to be liquidated by an offsetting transaction or fulfilled by a physical delivery.  The futures market can seem curious to newcomers in that it is a zero sum game, with every buyer having a seller and every seller having a buyer, hence the total of all long open interest is always equal to the total of short open interest contracts.

Open interest data can provide us with three key persectives on a particular market. First, and perhaps at its most basic, it provides us with a measure of market liquidity.   Second, it can give us an insight into the total number of participants in a particular contract and whether it is shrinking, expanding or remaining steady.    Finally, open interest provides us with a view on whether a particular market is “attractive” to market players by drawing in funds that would otherwise be used for purchasing other assets.    However, any analysis of open interest must be carefully considered and not taken in isolation as whilst it can be a valuable trading tool it is only one of many and should be used as a gauge of market sentiment and one which can help us with the longer term picture.

In my opinion the best way to use the open interest data is to view it against the spot price chart to which it relates and from which we can draw a number of conclusions.    However, it is vital to understand that open interest is NOT the same as trading volume.  Trading volume represents the total number of contracts that are traded in a day, or whatever timescale you are considering, and that volume includes both squared off  and new positions.  When a new buyer and seller are matched this represents new positions and would count as one new contract whereas closing or squaring positions between existing market participants would not add to the open interest total.  Volume is therefore a measure of the trading activity whereas open interest is much more a indicator of market sentiment.

1.   If  prices are rising and open interest is increasing this is a bullish signal as it implies the entry of new traders into the market who are opening new long positions which therefore suggests a fresh influx of money.

2.  If open interest is increasing while prices are falling could be a bearish signal.  Whilst this may appear contradictory it is generally considered that the influx of funds in this scenario is probably being used for fresh short positions which will therefore lead to further falls in the price.

3.  If the price is rising but open interest is falling this can be interpreted as a precursor to a possible trend reversal.  In simple terms the lack of any additions to the open interest indicates that prices are rising due to short sellers covering their existing positions.

4.  If prices are falling along with the open interest this can be attributed to forced squaring off of long positions. It can therefore be considered as representing a possible trend reversal since the downtrend is likely to reverse after these long positions have been taken out.  To summarize, falling prices with declining open interest can be considered a strong indicator of a potential market turn to the upside.

5.  When prices are moving sideways and we see a rise in open interest we can expect a significant move in either direction which is almost impossible to predict.

6.  If the open interest falls whilst the market is consolidating we can assume that this sideways price action will continue for some time.

The first example of this is now available on the cot report site where you can find an analysis of the open interest for gold against the spot gold chart for the past 2 years.

Am currently working through the COT data and hope to publish open interest charts for silver, oil and some of the currencies.

Good luck and good trading.

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