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The sky was falling last week.

The Dow Jones Industrial Average lost more than 500 points (its worst one-week performance in more than four years), and a variety of commodities corrected. Gold shed $40-plus as investment funds dried up. In other words, there were few places to hide.

Yet one obscure market held like a rock and actually gained ground–we discussed the opportunity in cotton two weeks ago in Commodities Trends:
Cotton remains the cheapest commodity on the board, relatively speaking. December cotton hit contract lows last week–much to my surprise, because December cotton is “new crop,” not even planted yet. You’d think with corn and soybeans and just about any other crop suitable for planting on cotton ground generating a much higher money return, farmers would opt to plant less cotton this coming year.

Less cotton should mean higher prices longer term. I don’t advocate bottom-picking. Even though this market appears “cheap,” rather than just buying and holding, I’ll wait for a technical sign of a bottom before stepping in.

Open interest (OI)–the number of outstanding contracts–is showing an interesting configuration, however (the red line on the chart below). Note how OI began to drop last week after hitting a new high recently. This is a potential sign the smart money (these would be the shorts; after all, they’ve been right to this point) are starting to quietly liquidate their positions. The old, weak longs are also liquidating, throwing in the towel, so to speak. This is a potentially bullish sign, so we’re keeping cotton on our radar.

December Cotton–02/20/07


Source: Commodity.com

Now take a look at the most recent chart, updated through Friday, March 2. Note how the volume surged right at the bottom as ownership was transferred from weak longs to stronger longs.

December Cotton–03/02/07


Source: Commodity.com

The February 20 close was 5,715; Friday’s close was 5,868. A move from 5,715 to 5,868 is equivalent to $765 per contract traded. As a result, I’ve been receiving a lot of questions on this thing called “open interest.” What is it, and how can it help us make money?

Open interest (OI) analysis is a powerful trading tool, yet most people don’t understand exactly what it is or how it works. The reason is that OI isn’t a statistic available in the stock market; it’s only found in commodity futures.

The following excerpt from my book Trading Commodities and Financial Future: A Step by Step Guide to Mastering the Markets offers more detail:
Open interest is quite simply the number of contracts outstanding. The total number held by buyers or (not and) sold short by sellers on any given day. The open interest number gives you the total number of longs and the total number of shorts, because in futures, the short interest is always equal to the long interest. Each long is either willing to accept delivery of a particular commodity, or to offset his (her) contract(s) at some time prior to the expiration date. Each short is either willing to make delivery or to offset his (her) contract(s) prior to the expiration date. With this in mind, you can plainly see that open interest is a measurement of the willingness of longs and shorts to maintain their opposing positions in the marketplace. It is a quantitative measurement of this difference of opinion.

Open interest numbers go up or down based on how many new traders are entering the market and how many old traders are leaving. Open interest goes up by one, when one new buyer and one new seller enter the market. This act creates one new contract. Open interest goes down by one, when a trader who is long closes out one contract with someone who is already short. Since this contract is now closed out, it disappears from the open interest statistics. If a new buyer buys from an old buyer (who is selling out) total open interest remains unchanged. If a new seller buys back or covers from a new seller entering the market, open interest also does not change. The old bear had to buy to cover with the other side of this transaction being a sell by the new bear.

Let’s look at a typical example. If one day heating oil has a total open interest of 50,000 contracts, and the next day it rises to 50,100 this means 100 new contracts were created by 100 new buyers and 100 new sellers. Or perhaps 10 new net buyers and sellers of 10 contracts each, or whatever it takes net to create the new 100. Of course, during that day many people closed out, many entered, but the net result was the creation of new open interest. 50,100 contacts worth of shorts and 50,100 contracts worth of longs at the end of the day. Theoretically, one short who had 100 new contracts sold (probably the ‘smart money’) could have taken the opposing side of 100 others who each bought one (the ‘majority’ probably the ‘dumb money’), but the short and long interest are always the same on any particular day.

Open interest figures are released daily by the Exchanges, but they are always for the previous day, so they are a day old. A trader can chart open interest on a price chart, and the direction it is changing can tell you some interesting things.

Open interest statistics are a valuable tool, which can be used to predict price trends as well as reversals. The size of the open interest reflects the intensity of the willingness of the participants to hold positions. Whenever prices move, someone wins and someone loses; the zero sum game. This is important to remember because when you think about the ramifications of changes in open interest you must think about it in the context of which way the market is moving at the time. An increase in open-interest shows a willingness on the part of the participants to enlarge their commitments. Let’s say the market is moving lower, and open interest is increasing. You can assume that some of hurt longs have left the party, but they are being replaced by new longs and many existing longs are still there. If they were liquidating en-masse, open interest would drop. Or, if the short holders were on balance taking profits and leaving the party, open interest would also drop. However, since the open interest is increasing, and the price is dropping, you can assume the bulls are losing money, but many must be hanging in there and/or they are recruiting buddies at an increasing rate. What are the ramifications of an open interest decline? It is a sign that the losers are in a liquidation phase (it doesn’t matter which way the market is moving), the winners are cashing it, and new players are not entering in sufficient numbers to replace them.

The next section of the book delves into my Six Profit Rules for Analyzing Open Interest. Rule #4 identified the profitable opportunity in cotton:
Rule #4: If prices are in a downtrend and open interest is falling, this is a bullish sign. The smart money, the shorts are covering or liquidating. They will be replaced to a degree by new shorts not as strong as they were, but the declining open interest indicates the weakened longs are throwing in the towel to a major degree. They will be replaced by fresh longs who were not as weakened by the lower prices as the old longs were. Another way to look at Rule # 4; when the pool of losers is depleted, the party will be over for the shorts.

This rule pertained directly to the cotton buying opportunity identified in the Feb. 20 issue because cotton was in a definite downtrend (the December contract was at contract lows at that time) and OI had begun to drop from record-high levels.

Now a special offer: If you’d like to receive all Six Profit Rules for Analyzing Open Interest, you can either buy my book, subscribe to Futures Market Forecaster (you’ll receive my book as part of the subscription) or e-mail me at info@commodity.com and I’ll reply with a complimentary list and explanation of the Rules. If you e-mail, please write “Open Interest” in the subject line.

Good luck, and good trading.

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Risk Disclaimer
Futures and futures options can entail a high degree of risk and are not appropriate for all investors. Commodities Trends is strictly the opinion of its writer. Use it as a valuable tool, not the “Holy Grail.” Any actions taken by readers are for their own account and risk. Information is obtained from sources believed reliable, but is in no way guaranteed. The author may have positions in the markets mentioned including at times positions contrary to the advice quoted herein. Opinions, market data and recommendations are subject to change at any time. Past Results Are Not Necessarily Indicative of Future Results.

Hypothetical Performance
Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.