Basics of open interest in the futures market
Basics of open interest in the futures market
Opening a position, increasing it then closing it
For this story we will use 3 traders that hold no futures contract
| Trader Name | Number of futures contract |
|---|---|
| A | 0 |
| B | 0 |
| C | 0 |
Since they hold no future contract we say they are "flat".
There are two types of future contracts : long contract and short contract.
If we create a long contract, we think price will increase.
if we create a short contract, we think price will decrease.
If we want to create a long contract, we MUST find someone willing
to create a short contract with us.
Example: At price 7, trader A wants to long, trader B wants to short. We can write it:
A long 7 short B
They do the trade, shake hands, and contracts are created out of thin air.
Now "A" holds 1 long contract and "B" holds 1 short contract. We write with a "+" people that hold long contracts and "-" people that hold short contracts.
| Trader Name | Number of futures contract |
|---|---|
| A | +1 |
| B | -1 |
Due to the rule of "to create 1 long contract there must be 1 short contract", "total number of long contracts" = "total number of short contracts" at all time.
When traders go from 0 to a specific position side (either long or short) we say that they "opened a position". Here, "A" has opened a long position and "B" has opened a short position.
"A" and "B" decide to deal again together for 1 extra contract:
A long 7 short B
| Trader Name | Number of futures contract |
|---|---|
| A | +2 |
| B | -2 |
Here we say that both traders have increased their position. When we talk about "increasing a position" we mean in absolute value. Trader B is negative, so increasing her position means she becomes even more negative.
Now "A" wants to go back to 0 (become flat again) how can she do it?
She has to create 2 short contracts. Lucky for her, trader "B" also wants to go flat. To go flat "B" needs to create 2 long contract.
B long 7 short A, for 2 contracts.
| Trader Name | Number of futures contract |
|---|---|
| A | 0 (+2 - 2) |
| B | 0 (-2 + 2) |
A and B are back to 0, we say they have "closed their position" or "flattened their position"
Note that in futures, you can only have a single position that is either long (+) or short (-).
If we hold 5 long contracts (+5) and 3 short contracts (-3) we don't have 2 positions. We have a single position that is long (+2).
What is open interest and how it changes
open interest is the number of opened contract on one side.
One side means either the "+" side or the "-" side (these numbers are always equal as we know). Back to our traders. "A" and "B" want to re-open a position at 7.
A long 7 short B
| Trader Name | Number of futures contract |
|---|---|
| A | +1 |
| B | -1 |
the total number of contracts on the long side is (+1) so Open Interest = 1.
A and B re-open for 2 contracts, what is open interest now?
A long 7 short B, 2 contracts
| Trader Name | Number of futures contract |
|---|---|
| A | +3 |
| B | -3 |
| --- | --- |
| Open Interest | 3 |
When two traders increase their position, open interest increases.
Now trader C comes in the game and wants to long 1 contract while A decides to decrease it's position by 1 contract.
C long 7 short A
| Trader Name | Number of futures contract |
|---|---|
| A | +2 (+3-1) |
| B | -3 |
| C | +1 (0+1) |
| --- | --- |
| Open Interest | 3 |
When one trader increases its position while the other one reduces its position, open interest doesn't change.
Finally, both A and B want to reduce their position by 2 contracts
B long 7 short A, for 2 contracts
| Trader Name | Number of futures contract |
|---|---|
| A | 0 (+2-2) |
| B | -1 (-3+2) |
| C | +1 |
| --- | --- |
| Open Interest | 1 |
When both traders reduce their position, open interest decreases.
To remember
To understand how open interest changes is easy :
Both traders increase their position -> Open Interest increases
Both traders reduce their position -> Open Interest decreases
1 trader increases the other reduces -> Open Interest stays the same
How to use the order book and open interest to know who is doing what
We know that the order book contains mainly 3 categories of orders :
- Take Profit
- Limit orders (People who think price will reverse after their position is opened)
We know Stop-Loss orders cannot be in the order book, these must be market orders.
We also ignore "book loss" order in this post.
A take profit means you reduce your position size.
A limit order means you increase your position size.
Now let's imagine different scenarios
Uptrend scenarios
Price goes up, Open Interest increases
Price goes up so active buyers are attacking the bid and increase their position. Open Interest is going up so both active buyers and passive sellers are increasing their position.
Which means...
Orders from the passive sellers are necessarily limit order.
Price goes up, Open Interest constant
If price goes up, active buyers are attacking the bid, so they increase their position. if open interest does not change, it means that passive sellers are reducing their position.
Orders from passive sellers are necessarily take profit.
Nothing special to say for this case, we're just reaching a wall of orders.
price goes up, Open Interest reduces
Here it's interesting.
Open Interest Reduces so both active buyers and passive sellers are reducing their position.
For passive sellers we understand: it's take profit.
But for active buyers, price is rising, so if they're not increasing their position, what's happening?
Two letters : SL
Do you remember those limit orders from the passive sellers? They thought price would reverse but they were wrong. Now their stop-loss is triggered. The Stop-Losses actively buy at market price to reduce the sellers position while those who bought at the beginning are now taking selling to take their profits.
This is a capitulation.
Stagnation scenario during an uptrend
price stags, open interest spikes up
it's a trap. passive sellers absorb in mass the active buyers. Active buyers are not powerful enough to push the price higher. That's a strong indication of a returnal.
Buyers will be trapped when price goes down and their SL will be triggered making the price go even lower.
price stags, open interest increases
it means that there are sellers building a potentially big short position. That could mean the end of the trend and a reversal.
price stags, open interest constant
this can mean no transaction happening (check volume)
if there is volume, buyers are increasing their position while sellers are taking their profit and there's enough seller taking their profits to block the uptrend for now.
price stags, open interest decreases
_TODO
price stags, open interest spikes down
This means a lot of stop-losses have been absorbed by lots of take-profit.
If we're at a local price maximum or price minimum, it's a clear sign of a reversal to come.
Advanced considerations on open interest
Open Interest is no holy grail, it indicates potential areas for tight SL and huge amount of profit.
We can use it for 3 cases :
- breakout
- trap
- SL liquidation
The higher the timeframe the more powerful it is.
Open Interest can be seen as $USD value or as delta