Open Interest And What It Means For Your Trades

Open interest is a popular tool used to determine whether the current trend is sustainable or ready for a reversal. Today we’ll explore what open interest is, why it’s important and how you can use it to your advantage when performing technical analysis.

Open interest represents the total number of unsettled derivative contracts, such as options or futures. It provides a trader with an insight into whether money flows into futures and options are increasing or decreasing. An increase in open interest represents new or additional money coming into the market, contrary to a decrease that indicates money flowing out of the market.

In order to fully understand why this is the case, one must first gain expertise in options and futures. Both of them are essentially contracts between two parties that give holders the right to buy or sell an underlying asset at a certain price within a specific amount of time. Unlike futures, where the holder is required to buy or sell the underlying asset, options, as the name implies, leave the holder with an option to either take an action or not.

Now, since perpetual futures contracts are by far the most popular derivatives in crypto, that’s what I’ll be talking about here. Options open interest is a whole other can of worms, and it’s something that I can get to in another post if people want to see that. Perpetual futures are basically futures contracts that don’t have an expiry date, and their price is kept close to the price of the underlying asset by means of funding rates.

Open interest is created when buyer and seller agree on a new contract and it increases with each contract created. Contrarily, when buyer and seller both terminate a contract, open interest decreases. It’s crucial to understand that open interest only changes when a new buyer and seller enter the market and create a new contract or when existing buyer and seller both agree to close their positions. Also open interest represents the number of contracts in existence and not the number of shorts and longs combined. For example: if trader A buys 1 contract and trader B shorts (that is, sells) 1 contract, the open interest will increase by 1 and not 2.

As already mentioned, open interest is used to determine the trend’s strength. As increasing open interest represents additional money and interest coming into the market, thus it’s usually interpreted as confirmation of continuation of a trend. In contrast, a decline in an open interest signals money flowing out of the market and indicates a potential reversal in the trend.

If the price of an underlying asset has been rising lately, increasing open interest suggests a continuation of a trend as new money is entering the market. Contrarily, deceleration in an open interest following a sustained move up in the price of an asset signals that momentum behind a trend is slowing down and the direction of a price might soon reverse. Usually the reason behind the price’s rally lies in the shorts covering their positions.

Similarly, if the price of an asset has been falling lately and the open interest has been increasing, the trend is there to stay as it signals new shorts coming into the market. As opposed to a combination of both falling price of an asset and open interest, which is interpreted as a herald of trend reversal, since the latest fall in price is attributed to long position holders selling in order to prevent further losses.

Here’s a summary of that:

Another thing to note with open interest — and this is perhaps the most important way to use it for me personally — is that it can tell you what phase the market is in.

For this it’s best used together with funding, and here’s a recent example:

Compare what was happening from December to mid April to what was going on from late July. In the first run, funding was really high and open interest grew quickly, meaning that everyone and their grandma was getting overleveraged and long. On the other hand, before BTC started the recent rally, funding was mostly negative, meaning that traders were aggressively short. What’s more, when the rally began, the funding never really got significantly positive. What do those two things tell you?

First, there were plenty of trapped shorts ripe for the squeeze. Secondly, no one was convinced of the rally. Those two things together mean that the market was (and is!) most likely in a disbelief rather than a complacency phase. Long story short (pun intended): BTC could quite easily see new ATHs this year.

To sum it all up, it is important to note that lots of analysts interpret previously outlined indicators contrastingly. One of the well known contrarian indicators is RSI, which I had analysed the previous week.

It’s crucial to look at many different theories and indicators as their effectiveness varies among different assets. I encourage you to do the backtesting yourself and figure out not only what works best for each asset, but also according to your investing strategy.