The Only Indicator You Will Ever Need
Basics of Volume and Open Interest
by Jason Alan Jankovsky, editor, speaker, and coach. July 10, 2008Print
What makes a winning trader consistent? It’s my opinion that successful trading for the long term is not possible without a sound understanding of both trading psychology and market psychology. The market-generated information that discloses this best is the study of volume and open interest; not prices. Often individual traders focus so heavily on the results they are seeking that they forget that every other trader out there is doing the same thing: attempting to profit from price action. No matter how you slice it; you can’t win consistently unless you do something better than the other guy. A solid understanding of volume and open interest will get you there.
Futures and FOREX trading is structured as a zero-sum environment. This means that in order for a price to print, both a buying order and a selling order must be matched at the current traded price; otherwise no trade happens and no new price will print. Therefore, the issue of potential price change from orders being placed and filled is what ultimately creates the price action traders are attempting to capture as a profit to their individual accounts. As competing orders are matched, resulting in either more futures contracts initiating a new position or closing an old open position (regardless of profit or loss to an individual account) becomes volume and open interest.
Your Starting Point:
One of basics to better understanding volume and open interest is to understand it from the point of view that it represents individual traders who all can’t be right as far a profit is concerned. Someone must liquidate to take a loss. Since most traders have a large portion of losing trades as their results over time; it follows that a lot of what is causing a price change must be losing trades being liquidated. By understanding that a large portion of volume and open interest (when it changes) must mean a change in the value of someone’s account balance; it becomes a bit better to understand where and when a turn in the market might be coming. Why? Because the people who helped put prices where they are now may have left the market completely; someone else has taken their place or not—that person has a completely different point of view on the market price and he might be in the wrong place too. He will liquidate sooner or later as well. With that in mind, let’s discuss some of the basics to volume and open interest.
volume is the total number of contracts being trading for a period of time. You can think of volume as the amount of orders passing through the market place as a total; most commonly calculated on a per day basis (daily volume)
Think of Volume as fuel.
open interest is the total number of contracts that remain open and held through at least one trading day (Overnight at least) You can think of open interest as the number of contracts someone is willing to hold at least for a period of time needed to realize a profit or loss.
Think of open interest as probable losers.
Prices do not have to move in order for either volume or open interest to change; but usually a change in either volume or open interest will create a price change or signal that a change in price is coming. The reason a change in volume or open interest can signal a change in price or create a change in price is because as the price moves—that movement is creating an open-trade gain or loss to someone and sooner or later that someone will need to liquidate his position and leave the market. It doesn’t really matter what the individual result to any one account might be; the fact is—you can’t “win” forever or “lose” forever. Sooner or later everyone must liquidate. This is why volume and open interest will change. Traders are initiating and then liquidating their positions. It is the change that signals where a potential price reversal might be developing.
Think of a change to V/OI as “something's going to happen”
How to use V/OI
When volume is high; individual traders in large numbers are participating. Most losers trade in small lot sizes so when volume is high that often means a lot of potential losers are active.
When volume is low; traders are not participating to a large degree.
When open interest is rising; traders are opening positions and assuming the risk that price will create a gain for them over at least one day. Someone willing to stay in the market more than one day is usually a larger, more experienced and better capitalized trader; in other words professionals that know what they are doing.
When open interest is falling; traders are closing positions (liquidating) and they are either accepting their loss or taking their profit. This is usually the smaller trader taking his loss and it is a professional on the other side of the trade.
The study of volume and open interest is the study of “Who is participating and are they getting in or out with a gain or loss?” Discerning what this means to potential price movement coming over the next period of time forward is where volume and open interest can be a good clue as to whether a market is ready to fall in price or rise in price.
Common Potential Meanings from Volume and Open Interest Changes
- Price rising, volume dropping and open interest dropping:
Market is running out of traders willing to open or hold an open long. Traders are liquidating both loosing short positions and closing winning long positions. A higher probability the market is set to retrace in price lower at some point forward. The market is running out of fuel.
Should prices be falling when this scenario develops, the market has a higher probability of a price rise at some point forward.
- Price rising, volume rising and open interest rising:
Market is attracting larger numbers of traders willing to open positions from the long side and hold them. Traders are more confident that prices will continue to climb in favor of a working long. This scenario is a good clue that uptrend is secure and that the trend may continue further for a period of time. The market has a lot of fuel and the professionals are letting the loser into the game.
Should this scenario develop while prices are falling, it is a good indication that downtrend is secure and that the trend may continue for a period of time.
- Price rising, volume dropping and open interest rising:
Market is attracting late buyers and early shorts; market is vulnerable to a sharp correction but likely that that correction will be bought creating a buy point for uptrend. Professionals need the loser’s blood to add to winners and will use the correction against trend to add with the trend.
If this scenario should develop while prices are dropping, it is a good indication that a sharp rally against downtrend will develop creating a sell point for downtrend.
- Price rising, volume rising and open interest falling:
Market has a lot of traders initiating from both sides but larger traders may be liquidating into the higher prices. The market may be vulnerable to large price swings as shorter-timeframe traders attempt to trade from both sides of the market but liquidating before end-of-day. Often a signal of a market turn near-term or continued volatility. More common at significant tops (or bottoms).
Losers are executing against other losers while professionals liquidate to end the trend.
Should this scenario develop as prices are dropping, it is still the same quality of market action. Often this is a sign of a significant bottom.
It should be noted that a brief discussion of the basics of volume and open interest cannot take the place of deeper study into market structure. V/OI is only one clue to potential market price action and no market condition is 100% definable from simply a brief understanding of the V/OI picture at any one point in time. V/OI is best used as confirmation tool when selecting price points that you personally expect the market to move away from creating a potential opportunity.
In closing, V/OI can be a powerful tool to help uncover good directional potential in any market you are trading. As someone serious about building a strong market presence you would be served best if you made a commitment to learning how this critical series of indicators can work. Additionally, it would be wise to use the Commitments of Traders reports produced by the CFTC as a compliment to your V/OI study. Often misunderstood, the COT report when combined with a solid understanding of V/OI, will give you a good confirmation clue that something is changing across a broad range of market participants. Good Luck and Good Trading.
Trading Futures, Options on Futures, and off-exchange Cash Foreign Exchange (FOREX) involves substantial risk of loss and may not be suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change at any time. The information contained in this article does not constitute a solicitation to buy or sell by the author or his affiliates and is not to be available to individuals in a jurisdiction where such availability would be contrary to local regulation or law.
© 2008 Jason Alan Jankovsky
Jason Alan Jankovsky is a 20+ year veteran of leveraged transaction trading. Trading extensively in Futures, Options, and FOREX since 1986, first as a customer and then as a registered broker, he is self-taught and self-educated. Working in almost all facets of the business, he has authored several trading systems, trained other successful traders and has been published in many industry periodicals; his numerous articles on global cash FOREX have appeared in "Traders Savvy", "The Perspective", “SFO Magazine” and other industry publications. He is the author of "Trading Rules that Work: The 28 essential lessons every trader must master" (Wiley & Sons, October 2006), an Amazon top-100 best seller under “Futures”. His second book for Wiley & Sons is due to be released in October, 2008 titled “The Art of The Trade: what I learned (and lost) trading the Chicago futures markets” He has focused on the psychology of trading as the key component to a successful trading methodology and teaches a six-week course on trading psychology every quarter to traders around the world. He appears regularly as a guest speaker at many public and private trading forums and has been invited to speak at round table discussions offered by events such as “The Orlando MoneyShow” Born and raised in Chicago, IL. He is an avid Sailor and Private Pilot.
Special note: Jason Alan Jankovsky can be reached for live appearances, educational webinars, and coaching by reaching his publicist, Kristina Vasilakis at 440-567-4349.
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