I got the idea for writing this post yesterday afternoon when I saw a full precious metals ultra bull site talking about the “surge” in silver open interest and got a little perturbed with how this information was being used to suggest to their readers that this was a bullish sign, setting up for higher prices in silver in particular.
I was a little late in publishing it, after witnessing today’s bloodbath in the metals space, but, I think the point is actually visualized better now in light of what happened.
There is a misconception about open interests that needs to be discussed. Too many people simply regurgitate information because it comes from a bullish source. Often, that information goes unchecked, is repeated again and before we know it, we have a situation where incorrect information has spread like wild fires.
It should be noted that increasing or spiking open interest is NOT so much an indicator of price direction (up or down) but instead speaks more to increasing volatility. No clearer is that point driven home than today’s action in the precious metals. Furthermore,neither increased volatility or a surge in open interest is a price "direction" indicator, only that any resultant move or the trading of that security has the 'potential' to be more violent or volatile (in either direction).
A declining open interest AFTER a significant price advance can be an indicator of waning momentum but the "surge" in open interest at this stage for silver is not a lead indicator for price advancement but instead is only fore-telling the return of increased volatility/interest.
Keep in mind that there is often a fallacy among the perma bulls when it comes to discussing this very point. What many of these conveniently leave out of their data interpretation is that for every long contract there must be a short (counterparty). So, using a very simple number/example, if there is a sudden spike in open interest, say, 100 contracts, there must be an equal amount of bets the other way. There has to be a counter party to every new position.
Therefore a change in open interest indicates a difference or change in the number of buyers and sellers of the underlying interest and has no price direction component, it is just a tally of unsettled contracts and used as just another analytical tool.
Now there is a caveat to this thinking. Open interest can be a price direction indicator ONLY IF it occurs in conjunction with a major price move because increasing open interest essentially means that new money is 'entering' the marketplace. The result will/could be that the present trend (up, down or sideways) will continue to stay in place. However there is less directional guidance associated to an increase in open interest when the market had been sideways as it had been. As an example, if silver had just moved 10% over the course of a few trading days and we then saw a surge in Open Interest, this could be a bullish indicator. However, if the market has been sideways like silver has been, there is no price directionality associated with the increase in open interest.
Think of it this way … start likening open interest to “interest”. When open interest rises it means there is more INTEREST in the underlying security. THIS IN TURN is a better read on the increase in volatility about to appear within that security. The more people invested in something = the greater chance of volatility as there are more people involved in the trade. Get it?
So, while we may have had a surge in open interest yesterday, it was not confirmed with a spike in price which in my view, could not have been used to predict price movement, but instead simply more "interest". Bulls may argue that because of that spike, the “cartel” had to step in today to prevent an upward explosion. Pure hogwash!
I was discussing this with a friend last night and he stated quite clearly that he also doesn’t see how any "surge" (it wasn't really that big a change, only 4k contract increase, on 166k total?) on a relatively uneventful price day could be any sort of price leader. OI increase/decrease without price movement tells you very little.
In his views, he would want to see a DECLINE in open interest on a big decline in price which would make him more bullish because it would indicate longs capitulating and shorts covering.
As we concluded in our discussion, the silver perma bulls have been ignoring the open interest data when convenient, as the very COT data they feverishly analyze PROVES that it's not the evil cartel using naked shorts to manipulate price lower... Furthermore, we've seen many days where exactly what I mentioned above happens: price declines and OI declines. when that happens, you CANNOT blame it on "CARTEL NAKED SHORTS" because that would result in an increasing (or stable) OI if the selloff was from shorts being increased.
My friend pointed out the following examples that I hope illustrate the point to my readers.
- If I'm long, and I sell to you, who has no position, OI doesn't change. (someone is still on the other side of "my" contract, which is no longer mine, it's now yours)
- if I'm long and I sell to our friend B (evil cartel member), who was short, OI decreases. (neither “B” or I now have a position - one contract has been "settled" or whatever you want to call it - closed out).
- if I have no position and I short a contract to you, who had no position, OI increases - there's a new "bet" out there. me vs you.
- If I have no position and I short a contract to B, evil cartel member, who was already short, OI is unchanged - I've "taken over" B’s short, essentially.
As it turns out, the silver bull camps that trumpeted yesterday’s increase in open interest did so without explaining the relatively insignificance of it, absent a significant price movement to support their position. What they should have said was that the increase in OI would have increased volatility. As we saw overnight and this morning, this has been shown to be true in this instance.
