Futures For You
INSIDE THE FUTURES WORLD

Want to learn how the futures markets really work? Dan O'Neil, a principal at online futures and forex broker Xpresstrade (www.xpresstrade.com), responds to your questions about today's futures markets.

To submit a question, post your question to our website at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
Dan O'Neil

OPEN INTEREST AND WHAT IT SAYS

What is open interest and what can it tell me about a market?

Open interest is the total number of futures or options on futures contracts that have not yet been offset or fulfilled by delivery. Open interest is an indicator of the depth or liquidity of a market, which influences the ability to buy or sell at or near a given price. Because good and timely fills can be hard to obtain in illiquid markets, many traders see very low open interest in a market as a reason to steer clear.

As an analysis tool, changes in open interest can be used to help confirm technical signals, helping traders gauge how much money is flowing into or out of a given market. This is helpful when looking at a trending market. If open interest is increasing, then the trend will probably continue in its present direction, either up or down. And if open interest is declining, this can be interpreted as a signal that the current trend may be about to end.

Open interest can have seasonal tendencies in some markets, higher at some times of the year and lower at others, making the seasonal average helpful in analyzing these markets. If prices are rising in an uptrend and total open interest is increasing more than its seasonal average (five-year average), new money is considered to be flowing into the market, indicating aggressive new buying -- a bullish sign. However, if prices are rising and open interest is falling by more than the seasonal average, the rally is probably losing short positions liquidating (short-covering), and money is leaving the market -- a bearish sign that often means the rally will fizzle.

The same holds true in a downtrend. Open interest increasing more than its seasonal average on the down move is a bearish sign, as new aggressive sellers are entering the market. But if open interest is declining more than the seasonal average on the down move, then it's likely that long positions are liquidating their losing trades (long liquidation), and the downtrend may be near an end.

Open interest can also be examined in conjunction with the Commodity Futures Trading Commission's (CFTC) Commitments of Traders (COT) report to see who's driving those numbers. Which leads us to…

FEAR OF COMMITMENT?

For a smaller trader, is there any point in paying attention to the Commitments Of Traders report?

This is a good question to pair with our discussion about open interest. After all, many veteran futures traders believe that open interest is best used as a secondary technical indicator, mainly helpful in confirming other technical signals on the charts. In other words, while traders won't base their decisions solely on the open interest number, they will use it in conjunction with other technical signals, or to help confirm signals. However, open interest can be very useful in identifying and confirming market situations and trading opportunities when examined in conjunction with the weekly Commitments Of Traders (COT) report.

The COT is a weekly report issued every Friday by the Commodity Futures Trading Commission (CFTC) providing a breakdown of each 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 COT report breaks down large trader positions into commercial and noncommercial categories by open interest. Commercial traders are required to register with the CFTC by showing a related cash business for which futures are used as a hedge, while the noncommercial category is composed of large speculators -- namely commodity funds. The balance of open interest is qualified under the nonreportable classification that includes both small commercial hedgers and small speculators.

Many small traders believe that the most important aspect of the COT report is the change in the net positions of commercial hedgers from the prior report (number of short contracts subtracted from number of long contracts). A positive result indicates a net-long position (more longs than shorts), while a negative result indicates a net-short position (more shorts than longs).

In general, commercials tend to hold a superior record to other trading groups in forecasting significant market moves. Why? Large commercials are generally believed to have the best fundamental supply and demand information on their markets, and thus position their trades accordingly. Large commercials also trade large size, which in itself moves markets in their favor.

Originally published in the January 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.

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