Techniques for analysing and trading equities, looking at price and
volume, can be applied to precious metal futures markets. Futures, however,
introduce another data point – open interest – that has to be considered.
With equities, the quantity of shares on issue is generally fixed and rarely
changes. Therefore all buying is done from sellers who hold the shares.
With futures, the amount of contracts “on issue” or “open” changes daily,
as a future is a contract to trade metal in the future and an exchange will
create, or open, as many new contacts as people wish to enter into. If a
seller of metal and buyer of metal want to enter into a contract, then a new
contract will be opened. If an existing seller of a contact (a “short”) and
an existing buyer of a contact (a “long”) want to exit their contract, then
the contact will be closed.
Open interest represents the number of contacts created and in existence
at a point in time. The table below summarises how open interest will change,
depending upon who is buying and who is selling.
In the cases where open interest doesn’t change – that is, an existing
long or short is being taken on by a new participant – there may be some
information value in knowing who is closing and who is new/adding. This can
be done by looking at the changes in the long and shorts held by the various
categories on the Commitment of Traders report (material for another post).
It should be noted that a change in open interest indicates very little in
and of itself as the opening or closing of a contact requires both
a buyer (long) and seller (short). However, looking at changes in open
interest in combination with changes in price may give an indication of market
strength, as summarised in the table below (see Wikipedia).
Note that increasing open interest can be associated with strong or weak
markets. The logic is that if the price is rising and open interest is
increasing, then buyers are having to increase their price to induce new
sellers into the market. If the price is falling and open interest is
decreasing, then longs are having to decrease their selling price to induce
shorts to cover and exit the market. The table above can be represented
graphically in the stylised chart below showing a rising and falling price
with a rising and falling level of open interest.
While this chart demonstrates the highly theoretical nature of the
price/open interest trading rule, there is some value in including open
interest in your market analysis, as demonstrated in the chart below of the
gold price during July 2015.
The light blue lines show the price falling while open interest
was increasing, and indeed the market was weak, subsequently breaking through
the $1140 support level. The light red lines show open interest decreasing
while the price continued to fall and subsequently the market bottomed. Note
that the chart also shows violations of the “rules”, so it is not fool proof.
The chart above also includes volume. While volume and open interest are
related (they have a simple correlation of 0.81 over 40 years) they do not
always move together, so one has to consider changes in both. Keep in mind
that, everything else being the same, increases and
decreases in open interest will both increase volume.
There are various technical indicators that combine price, volume and
open interest, such as the Futures Volume Open Interest (FVOI) Indicator (a
variation of On Balance Volume), which Sharelynx
calculates and maintains charts for.
For those coming from equity investing, it is important when analysing
futures data to remember that the precious metal markets are global and
significant volumes are traded in the opaque over-the-counter (OTC) market.
While Comex, and increasingly the SGE, have a significant impact on
prices, they are not self-contained markets like those for the shares of a
company.
Bullion banks and other traders arbitrage between futures markets,
ETFs and the OTC market (otherwise prices would not stay in alignment)
so action you see in public exchanges could be balanced by offsetting
positions in other markets that are not visible to you. The relative wealth
of data available on futures markets, and lack of data on OTC markets, can
lead analysts to become myopic and forget that there may be other market
forces from the OTC market impacting on the “visible” public exchange
traded contracts.
