Technical Indicators Tutorial : Strength and Sentiment Indicators
Although most technical indicators are based on price data and various manipulations of that data, a few are based on other market activity. For example, when prices make a move, how many traders are participating and who are they? Volume and open interest are indicators that reflect some basic numbers about how traders are driving the market, and Commitments of Traders reports reveal the caliber of participants involved.
Volume and open interest – In and of themselves, volume and open interest data may not be that valuable other than to indicate the liquidity of a market. But used in conjunction with price action, these numbers serve as a strength indicator that can provide some meaningful verification about the significance of a price move.
Volume is the number of transactions in a futures or options on futures contract made during a specified period of time, usually one trading session. One buy and one sell equals a volume of one.
Open interest is the total number of futures or options on futures contracts that have not yet been offset or fulfilled by delivery. It is an indicator of the depth or liquidity of a futures market, which influences the ability to buy or sell at or near a given price.
Open interest can be a little confusing. If a new buyer (a long) and new seller (a short) enter a trade, their orders are matched and open interest increases by one. However, if a trader who has a long position sells to a new trader who wants to initiate a long position, open interest does not change as the number of open contracts remains the same. If a trader holding a long position sells to a trader wanting to get rid of his existing short position, open interest decreases by one as there is one less open contract.
Volume and open interest are “secondary” technical indicators that help confirm other technical signals on the charts. If an upside price breakout is accompanied by heavy volume, that is a strong signal that the market may want to continue to move higher because it indicates more traders jumped on the rising prices. On the other hand, a big upside move or a move to a new high that is accompanied by light volume makes the move suspect and indicates a top or bottom may be near or in place. Also, if volume increases on price moves against the existing trend, then that trend may be nearing an end.
To validate an uptrend, volume should be heavier on up days and lighter on down days within the trend. In a downtrend, volume should be heavier on down days and lighter on up days. A general trading rule is that if both volume and open interest are increasing, then the trend will probably continue in its present direction. If volume and open interest are declining, this can be interpreted as a signal that the current trend may be about to end.
Changes in open interest can help a trader gauge how much new money is flowing into a market or if money is flowing out of a market, a valuable insight in evaluating a trending market. Open interest does have seasonal tendencies – that is, it is higher at some times of the year and lower at others in many markets. Look at the seasonal average (five year average) of open interest in your analysis.
If prices are rising in an uptrend and total open interest is increasing more than its seasonal average, it suggests new money is flowing into the market, indicating aggressive new buying, and that is bullish. However, if prices are rising and open interest is falling by more than its seasonal average, the rally is the result of holders of losing short positions liquidating their contracts (short covering) and money is leaving the market. This is usually bearish, as the rally will likely fizzle.
Here are two more rules for open interest:
- Very high open interest at market tops can cause a steep and quick price downturn.
- Open interest that is building up during a consolidation, or “basing” period, can strengthen the price breakout when it happens.
Commitments of Traders Reports – Open interest can be taken one step further by examining the Commitments of Traders (COT) report issued every Friday afternoon by the Commodity Futures Trading Commission (CFTC).
COT reports provide a breakdown of the preceding Tuesday’s open interest for markets in which 20 or more traders or hedgers hold positions equal to, or above, reporting levels established by the CFTC.
The report breaks down open interest for large trader positions into “commercial” and “non-commercial” categories. Commercial traders are required to register with the CFTC by showing a related cash business for which futures are used as a hedge. The non-commercial category is comprised of large speculators, mainly commodity funds. The balance of open interest is qualified under the “non-reportable” classification that includes both small commercial hedgers and small speculators.
To derive the net trader position for each category, subtract the short contracts from the long contracts. A positive result indicates a net long position (more longs than shorts). A negative result indicates a net short position (more shorts than longs). The results may mean different things in different markets, so it usually takes some experience with COT numbers before you can see their value in trading.
The most important aspect of the COT report for most traders is the change in net positions of the commercial hedgers. The premise of COT analysis is that commercials are the “ smart money” because they have a strong record in forecasting significant market moves, have the best fundamental supply and demand information and have the ability to move markets because of the large size they trade. That’s the side of the market where you want to be.
Some traders like to take positions opposite of what the COT report suggests that small traders (non reportable positions) are doing, assuming most small speculative traders are usually under-capitalized and/or wrong about the market.