Table of Contents
Before we move forward to learn about the rules of Open Interest (OI), let’s address the definition of futures contracts. As OI is pretty related to it. A futures contract is basically an agreement where you can purchase or sell something at a predefined price at a given point in the future.
Now, let’s get to know the meaning of Open Interest.
Introduction to Open Interest
The term “Open Interest” (OI) refers to the quantity of open futures (or options) contracts that are presently outstanding (open) in the market at any given time. Always remember that there are two parties to any transaction: a buyer and a seller. Let’s say the seller sells the buyer five contracts. The buyer would be said to be long on the five contracts, and the seller is said to be short on that same contract. There are reportedly five Open Interests in this case.
In other words, no new wealth is created; instead, it is moved between buyers and sellers. Derivatives are frequently described as a zero-sum game for this reason.
What does OI indicate, then?
The shift in Open Interest doesn’t really indicate a market direction. However, it does provide a sense of strength between bullish and bearish positions.
- More trades will be on the long side if the price and OI both rise.
- Longs are covering their position when both the price and the OI decline.
- More trades will be on the short side if the price falls while OI rises.
- Shorts are covering their positions if the price rises but the OI falls.
Short covering
A short cover refers to when the investors sell an asset that they do not actually own. Essentially, short selling is a means to bet on the fall of an asset’s price. Short covering is the process of repurchasing the borrowed asset from the lender to exit a short position. The transaction is finished once the assets are given back.
Long covering
Offloading or selling a position is known as unwinding. Long unwinding is the practice of selling positions or assets that have been held for a longer period of time to book profits or to exit them in advance of oncoming bearishness.
Importance of Open Interest
Open Interest (OI) is basically a measure of market activity. A minute or no Open Interest means there are either no available positions or almost all of the posts have been filled. High Open Interest indicates that there are numerous open contracts, which signifies that market participants will be closely monitoring that market.
A futures or options market’s Open Interest is a measure of the amount of money entering those markets. While falling Open Interest implies money leaving the market, increasing Open Interest shows new or more money entering it.
Options traders place a great deal of importance on Open Interest since it offers vital information about an option’s liquidity.
Since you know what Open Interest is and its importance, let’s see the eight rules of Open Interest that you need to consider before doing your futures trading.
8 Rules of Open Interest
The rules of Open Interest are written in many different publications, for instance, Investopedia. The following rules were, however, originally written by famous chartist – Martin Pring in his book “Martin Pring on Market Momentum.”
- “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, 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 in a position to rally again.”
Conclusion
Digital assets are traded continuously, in contrast to traditional stocks and securities, making them subject to fluctuations resulting from happenings on the world market at any given time. Therefore, by studying the current market situation and accurately interpreting sentiment, traders may make better-informed judgments on where to spend their capital by knowing how Open Interest affects Crypto prices.
Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.
