Open Interest:

What it indicates and how to use it

Open interest is an important measure to keep an eye on when trading futures and options. In this article, we’re going to take a look at what it indicates, how to use it, and how it’s related to price and funding rates. Effective analysis can give you a clear picture of the market and help you develop successful trading strategies.

What is Open Interest? 

Open interest is the total number of outstanding futures and/or option contracts that are held by market participants in a given time frame. It does not include closed positions or expired contracts; it only includes all active long and short positions in both put and call options as well as futures. It increases every time a new contract is initiated, and it decreases when a contract is closed.

What is the relationship between Open Interest and Price?

Understanding this data can provide important insights into price movements and market sentiment. It usually rises when the price of an asset is trending up, which indicates that there is bullish sentiment in the market. It also tends to rise when a financial instrument is becoming more volatile, as this signals that investors are taking more speculative positions. 

Open interest usually falls when the price is trending down or falling in volatility, as this signals that there are fewer participants in the market. It can also be used to assess the relative strength of a price trend by comparing it with historical data.

Open Interest Analysis

Analysis of this data can give you a clear picture of the market and help you develop successful trading strategies. Accurate analysis can be used to determine the best time for entering and exiting trades by looking at historical data of open interest. 

When Open Interest rises with Price, this is generally considered bullish as traders are continuing to take on new long positions, even at the new higher price. Therefore, the move up has momentum and support from buyers.

If Open Interest decreases as Price is rising, this suggests the move up will likely retrace. As Longs and Shorts must be balanced, the declining Open Interest is likely due to Shorts covering and buying to exit their position. This can lead to a dramatic squeeze up in Price, but it will usually retrace as the buying isn’t organic.

When Price drops whilst Open Interest increases, it is likely that Shorts are increasing which adds to selling pressure. Further, if there is a significant amount of Open Interest and Price drops too much, Long positions are at risk of cascading liquidations.

If both Price and Open Interest are decreasing there are two contrarian views as to what this means. It could be considered bearish as the market is not stepping in to buy and support Price – there is not positive sentiment from buyers. However, clearing excessive leverage is generally healthy for the market over the long term. As Open Interest is decreasing, this suggests that the worst of the crash is over and sellers are generally exhausted – leaving the possibility of a trend reversal.

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How does it relate to Funding Rates?

Open interest can also be useful for understanding the funding rates of a contract. It’s an important factor in calculating the swap rate, which determines how much a trader must pay in funding when they hold a perpetual swap contract. It can also be used to estimate the change in the swap rate as well as to spot potential arbitrage opportunities. If you want to know more about Funding Rates, you can find a useful article here.

Open Interest and Liquidations

Open interest can be used to analyse the risk of liquidation for traders who hold large positions in a particular contract. It indicates how many traders are currently long or short on a contract, and it can be used to determine whether there is sufficient liquidity to cover the cost of liquidations when a trader enters or exits the market. Analysis can also be used to predict when liquidations may occur in the future, by comparing current levels of open interest with historical data. This can be used to determine the best time for entering and exiting trades.

Using Open Interest data for Crypto Derivatives Trading

Open interest data can be used to develop profitable trading strategies, especially in the crypto derivatives market. Analysis is useful for understanding price movements, market sentiment and the risk of liquidation. It can also be used to estimate funding rates and spot potential arbitrage opportunities.

Disclaimer: Nothing within this article should be misconstrued as financial advice. The financial techniques described herein are for educational purposes only. Any financial positions you take on the market are at your own risk and own reward. If you need financial advice or further advice in general, it is recommended that you identify a relevantly qualified individual in your Jurisdiction who can advise you accordingly.

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