Derivatives: Interpreting open interest & volumes

Derivatives: Interpreting open interest & volumes

While the very core of derivative products is to manage risk, it is important to appreciate that all derivatives are highly geared, or leveraged, transactions. Traders/investors are able to assume large positions - with similar sized risks - with very little up-front outlay and the risk to the investor is high. A thorough grasp of product technicalities is only one aspect of the knowledge and skills that traders require. Every trader has a view of the market and their end objective is, of course, profit from that view. And the most effective route to achieving this is to form a view that proves to be correct, having positioned one's self to obtain the maximum profit from it. If a trader has a bullish he could go long in the futures market or choose to purchase a call option.

Before getting into a trade two questions have to be asked:

1. How do you decide whether "it's going up" or "it's going down"?

2. What other factors should you consider before putting on a position?

Technical analysis

As derivative products are influenced by the performance underlying stock, it is very important how is the stock going to perform in the short-term. This where technical analysis come handy. Whether you believe in them or not, everyone should know at least the basics, such as the current support and resistance levels and the likely effect of any breach of them. You may be sure that the scrip is fundamentally strong, but it is with technical charts that will tell you whether the scrip is going to move up in the short term. Your option strategies are also dependent on the correct 'view' of the market.

In the case of futures, technical analysis forms a good basis to take a view of the future movement. (To understand more about technical analysis, see Learning Centre). However, in the case of options, open interest plays a vital role in the way the contracts are going to move. The same has to be interpreted in conjunction with volumes.

Interpreting volume and open interest

While volume alone is not a useful determinant of market direction, used in conjunction with other data it can be very beneficial - especially to longer term traders - in identifying whether a continuation of or reversal in the prevailing trend is likely.

Most traders incorporate Open Interest data with their volume analysis. Open Interest is the net number of open bullish positions in a futures market.

Volume at low levels reflects uncertainty regarding the future direction of the market in question. Conversely, high volume suggests a high level of confidence in the future direction.

Low levels of Open Interest reflect a market lacking in liquidity and, therefore, one which will be relatively more susceptible to being moved by a trade than a more liquid counterpart. When there are high levels of Open Interest, deals are likely to be rapidly swallowed up by the market - due to the fact that there will be a vast array of participants eager to open new positions or take profits - and consequently have far less impact on the current price.

It should, however, be remembered that in Volume and Open Interest, the terms "High" and "Low" are always relative.

Nevertheless, it is possible to lay down some simple guidelines for interpreting these factors:

• If volume is relatively high while the market is going up and remains relatively low during corrections, the inference is that the market is in a strong uptrend, which should continue.

• If volume is high while the market is going down and relatively light during upward retracements, then the market is weak with a continuing downward trend likely.

• If both open interest and prices are increasing, then new buyers are being brought into the market with a strong technical picture unfolding. Expect the uptrend to continue.

• If on the other hand, open interest is increasing while prices decline, short sellers have the upper hand in a technically weak market. As open interest is growing while prices decline, buyers are obviously the more aggressive party.

• In the event of open interest declining while prices are also slipping, liquidation by long positions is the implication, therefore suggesting a technically strong market overall. In other words, the market is strong as open interest declining suggests no new aggressive shorts, as this would entail an increase in open interest.

• When open interest is declining and prices are increasing, short covering is the most likely cause suggesting that overall the market is weak - i.e. attracting new buyers would be required for a technically strong market and consequently open interest would rise.

For those without direct access to futures price data, volume and open interest can be obtained for virtually all futures contracts in newspapers or on financial websites.