Technical Analysis Demystified: Volume and Open Interests

The first 2 modules of “Technical Analysis demystified” were dedicated to major reversal and continuation patterns.

In this Knowledge Series, we look at how to use volume and open interests. 

ABOUT OPEN INTEREST

To understand open interest, we must first explore how options and futures contracts are created. If an options contract exists, it must have had a buyer. For every buyer, there must be a seller since you cannot buy something that is not available for sale.

The relationship between the buyer and seller creates one contract, and a single contract equates to 100 shares of the underlying asset. The contract is considered "open" until the counterparty closes it. Adding up the open contracts, where there are a buyer and seller for each, results in the open interest.

If a buyer and seller come together and initiate a new position of one contract, then open interest will increase by one contract. Should a buyer and seller both exit a one contract position on a trade, then open interest decreases by one contract. However, if a buyer or seller passes off their current position to a new buyer or seller, then open interest remains unchanged (source: www.investopedia.com).

The Open Interest is the total number of outstanding long or shorts (reported a day late).

It is important to note that open interest equals the total number of contracts, not the total of each transaction by every buyer and seller. In other words, open interest is the total of all the buys or all of the sells, not both.

If both participants in a trade are initiating a new position, the open interest will increase.

Once the existing positions are rolled over (e.g sells old long, buy new long), there is no change in open interest.

If both participants are liquidating positions, then there is a decrease in open interests.

 


GENERAL RULES ABOUT VOLUME AND OPEN INTEREST

When Prices INCREASE and Volume and Open Interest INCREASE, this is a Bullish signal (it means that new money is flowing into the market).

When Prices INCREASE and Volume and Open Interest DECREASE, this is a Bearish signal (it implies that there is a rally caused by short covering).

When Prices DECREASE and Volume and Open Interest INCREASE, this is a Bearish signal (it implies that aggressive short selling is taking place).

When Prices DECREASE and Volume and Open Interest DECREASE, this is a Bullish signal (it means that the price fall is caused by discouraged or losing longs being forced to liquidate their positions).

Towards the end of a major market move, when open interest has been increasing throughout the price trend, a levelling off or decline in open interest is often an early warning of a change in trend

A high open interest at TOP can be considered bearish if the price drop is very sudden.

If open interest builds up during a sideways consolidation or a horizontal trading range, the ensuring price move intensifies once the breakout occurs.

When prices rise and volume/open interest decrease, it often indicates a pending change of direction.

As a general rule, volume preceded price.

When Volume INCREASE and Open Interest INCREASE, the trend is confirmed.
When Volume INCREASE and Open Interest DECREASE, it indicates a positive liquidation
When Volume DECREASE and Open Interest INCREASE implies a slow accumulation phase
When Volume DECREASE and Open Interest DECREASE, it means that we are in a “congestion phase”.

 


VOLUME INDICATORS

Volume Momentum: the Rate of Change (RoC) Volume is calculated as such: [Volume today – Volume n days ago]

Volume oscillators: The Percentage Volume Oscillator (PVO) is the percentage difference between two moving averages of volume. The indicator is calculated with the following formula:

oscillator formula image

The oscillator fluctuates above and below zero, and a rising volume oscillator generally indicates increasing volume while a declining oscillator generally indicates declining volume.

volume oscillator

The Sibbet’s Demand Index combines price and volume into a leading market indicator

The Demand Index is complex technical indicator developed by James Sibbet that involves over 20 columns of data, but the goal is to provide a ratio of buying pressure to selling pressure. Traders can use this information as a leading indicator of where a security's price may be headed over the near‐term and the long‐term.

James Sibbet established six rules for using the Demand Index when the technical indicator was originally published. While traders may use variations of these rules, they serve as a great baseline for using the technical indicator in practice.

The six rules are:
1) A divergence between the Demand Index and price is a bearish indication;
2) Prices often rally to new highs following an extreme peak in the Demand Index;
3) Higher prices with a low Demand Index often indicates a top in the market;
4) The Demand Index moving through the zero line suggests a change in trend;
5) The Demand Index remaining near zero indicates a weak price movement that won't last very long;
6) A large long‐term divergence between the Demand Index and price indicators a major top or bottom.


The Aspray’s Demand Oscillator is the difference between BP (Buying Pressure) and SP (Selling Pressure)

For rising prices:
BP = volume;
SP = volume / [K x (Close today – Close previous) / Close previous]

For falling prices:
BP = volume / [K x (Close today – Close previous)/Close previous]
SP = volume

During a rising market, SP is divided by a % of volume (>1)

During a falling market, BP is divided by a % of volume (>1).

Thomas Aspray suggests using DI in three formats:
1) Plotting buying pressure (BP) and selling pressure (SP) as separate lines;
2) Deriving an oscillator of the BP/SP which he calls the Demand Oscillator (charted as a histogram), and,
3) The DI line itself (which can be charted as a line or as a histogram - although trendlines are more easily drawn on DI as a line)

Many experienced traders feel that weekly studies can be particularly important in identifying the predominant trend, and DI is often assessed using weekly data.

DI offers the following types of signals:
1) Divergences between DI and price. A divergence between the DI and prices suggests an approaching change in the price trend;
2) Trendline analysis of DI showing levels of support/resistance, can help determine changes in trend. As a leading indicator DI trendlines are often broken ahead of price trendlines;
3) Zero-line crossings can confirm previous signals as a lagging indicator.



The Chaikin Money-Flow is an oscillator that helps signal if a stock is undergoing accumulation or distribution. It is calculated from the daily readings of the Accumulation Distribution Line.

The CMF is unlike a momentum oscillator in that it is not influenced by the daily price change. Instead, the indicator focuses on the location of the close relative to the range for the period (daily or weekly).

It is created by subtracting a 10-period exponential moving average of the accumulation/distribution line from a 3-period exponential average of it.


Upside / Downside Volume is calculated by dividing Advancing Volume by Declining Volume.


The OBV (On-balance volume) should follow the same direction as the price trend (i.e it needs to be used as a divergence and coincident indicator). The Total volume is assigned a + or – Value. Then, the cumulative Total is calculated. It is the direction which is important.

obv

 

Richard Arm’s) Equivolume uses a unique approach of substituting volume for time along the bottom scale of a chart. When volume rise, the price chart is elongated to the right, rather than extending the height of the bar.

 


The Market facilitation index (MFI). In weighting the likelihood that prices are indicating a direction rather than a false start, the tick volume compared with the price range for the same period can compare the willingness of the market to move with prices.

It is calculated as such: range / Volume = (High – Low) / volume

When Tick Volume INCREASE and MFI INCREASE, the trend is confirmed
When Tick Volume DECREASE and MFI DECREASE, it indicates a false direction
When Tick Volume DECREASE and MFI INCREASE, the entry timing is most likely a poor one
When Tick Volume INCREASE and MFI INCREASE, it is potentially the start of a new trend

(Tick volume is measuring every trade whether up or down and the volume that accompanies those trades for a given time period).

 

Read our next article: Japanese candlestick charts to spot market reversals

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