Commodities in Classroom. What volume and open interest can tell you about commodities

Among the many tools to identify and predict the price trend of commodities, volume and open interest (OI) can be effective tools when it comes to trading in derivative contracts, i.e., futures and options (F&O).

OI is a measure of money flow in and out of the contract.

To be effective, both volume and OI data are generally used in conjunction with the price movement of the contract.

OI is basically the number of contracts outstanding at that particular time and volume is the number of transactions taken place in a trading session.

A change in open interest data can give fresh cues about the price action.

Volume and OI are different

Volume and OI data are often confused with each other. Both show the level of activity, but there are some key differences.

Volume begins every trading session at zero and it adds up as trading happens. Volume goes up for each transaction (buy and sell together) throughout any trading day. That is, when 100 contracts are being bought and sold in a day, volume for that day will be 100. Note that it will not be 200.

Unlike volume, OI will not always increase in every trading session and it is not zero at the beginning of the day. It goes up when new contracts are added and comes down when the existing contracts are liquidated.

To understand this better, let us see how open interest and volume data are measured.

For this, let’s consider five market participants (traders) —A, B, C, D and E.

Assume that Trader A buys 10 futures contracts of a commodity and Trader B sells 10 futures contracts of the same. When this transaction occurs, OI will go up by 10 contracts (volume will go up by 10 contracts).

Similarly, when Trader C buys 10 contracts and Trader D sells 10 contracts of the same commodity, OI will go up by 10 contracts (volume will go up by 10 contracts). After the above couple of transactions, the total OI and volume will be 20 contracts each.

But the catch comes next. When Trader A squares off, ie, sells the existing 10 futures long positions and Trader E buys the same, OI will remain the same because the new contract is not created whereas the existing contract changes hands, ie, Trader E will now be long. After this transaction, the OI will remain 20 contracts whereas the volume will be 30 contracts.

Now, when Trader B (who is holding short position) and E (who is holding long position) liquidate their respective positions, the OI will drop by 10 contracts. After this transaction, OI will be 10 contracts and volume will be 40 contracts.

That is, OI will increase only when the contracts are created afresh and decrease when existing contracts are liquidated. But volume goes up as and when transactions occur.

Reading the data

Using volume and OI data per se cannot provide clues about the trend. These data should be used along with the price action to identify the strength and the direction of the trend.

When price of a contract increases with an increase in volume and OI, the rally is considered strong and the trend is up.

When price of a contract decreases but volume and OI goes up, the downtrend is strong and the contract is most likely to drop further.

When the contract price increases but volume and OI declines, the uptrend is likely to come to an end and a bearish trend-reversal can be expected since long traders are potentially liquidating their positions.

Similarly, when the contract price decreases with a decrease in volume and OI, the downtrend might be heading towards an end and a bullish trend-reversal can be expected since participants with sell positions are probably covering their shorts.

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