In the world of trading commodities, it is important to look for as many clues as possible when making decisions. Analysis of markets requires discipline and hard work. However, that hard work can pay off when you are able to put the pieces of a complicated puzzle together. There are two types of analysis involved in the decision-making process. Technical analysis involves the study of charts, price momentum, and patterns. Fundamental analysis concentrates on the supply and demand picture—production versus consumption.
Two tools that I like to use in order to understand the market flow and sentiment in all commodities that trade on futures exchanges are volume and open interest. These two metrics often validate or invalidate price moves. Volume and open interest are important technical metrics when it comes to understanding price direction.
Volume is the total number of futures contracts traded in a specific market. The higher the volume, the more actively traded or more liquid a futures contract or commodity is. Technical analysts use volume as a tool because it confirms a price trend. When a market starts moving higher or lower in price the analyst will immediately investigate the trading volume during the price move. Rising volume along with rising price generally confirms or validates strong bull market action. Rising volume along with falling price generally confirms or validates strong bear market action. Technicians also employ volume as a tool to spot trend reversals. When falling volume accompanies rising or falling prices, a technical analyst will generally conclude that a market is running out of steam in one particular direction. It then becomes time to search for a correction point, usually support or resistance, where the price will reverse from the current trend.
Volume data is often available free of charge on many charting packages and can be viewed on commodities as well as other assets that trade on futures markets. While volume is one important tool, open interest is another important technical metric for traders and investors to monitor.
Open interest is the total number of open and not yet closed long and short positions in futures contracts for a particular commodity. While volume counts every contract that trades, open interest only counts those contracts that still have open market risk. This is a key tool when it comes to understanding what market participants are thinking and doing at specific times. Rising open interest indicates the strength behind a move. If a market is moving higher or lower and rising open interest accompanies that move it often signals validation of the direction of the move and that the price is likely to continue in that same direction. Decreasing open interest can signify that a market is entering a period of less active trading because market participants are not taking new positions and are closing out existing ones.
Fortunately, commodity exchanges such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE) publish volume and open interest data daily and in some cases in real time. The Commodity Futures Trading Commission (CFTC) publishes data called the Commitment of Traders to report on Friday afternoons each week. This report breaks down open interest according to different classes of market participants and outlines whether they are holding long or short positions. The CFTC report lists positions held by producers, merchants, processors, users, swap dealers, those managing money, other reportable positions, and non-reportable positions. This breakdown of open interest can be extremely helpful when it comes to understanding exactly who is doing what in a particular commodity futures contract.
Using volume and open interest together as part of your overall analysis of markets will help you to become a better trader or investor. Volume and open interest are two important pieces when it comes to solving the puzzle of markets and forming an educated and substantiated opinion on price direction.