(This is the 13th article in a series of articles on basic technical analysis originally published in Futures magazine.)

Traditional technical analysis focuses on price: How it reflects the psychology of the market place, how it is portrayed on a chart and how one price relates to another price. So anything that can confirm a price pattern or trend will interest a technical analyst.

That’s where volume and open interest fit. One unit of volume actually involves two trading decisions, one by a buyer and one by a seller. Whenever a buyer and a seller make a transaction, they produce a volume of one. The total volume of all these transactions is usually shown as a histogram at the bottom of a price chart.

Open interest is the total number of contracts remaining open – a buy that has not been offset by a sell or a sell that has not been offset by a buy. Open interest increases only when a new buyer and a new seller make a transaction that results in a new contract. If an old seller buys and an old buyer sells, they have produced a volume of one, but open interest decreases because they have just closed out an existing contract.

Conventional thinking is that any price move accompanied by heavy volume is a true reflection of market opinion. If a market breaks out of the chart pattern on large volume (compared to previous days), the breakout is confirmed. Low volume would make a breakout suspect.

Frequently, volume matches the pattern of prices, as shown by the arrows on the chart for sugar futures. When prices continue to go higher, but volume declines (A), it suggests the supply of buyers willing to push their opinion is getting smaller, and the uptrend is running out of steam. After a price spike, old traders who are shorting may give in and bail out. Longs may take profits, and bears may jump on the opportunity to establish new positions at higher prices. In short, it’s a high-volume day with a key reversal down as you can see on the chart.

Analysts look at volume and open interest in different ways, but here are typical interpretations:
Price up, volume up, open interest up – bullish
Price up, volume down, open interest up – no effect on value
Price up, volume down, open interest down – bearish
Price up, volume up, open interest down – no effect
Price down, volume down, open interest down – bullish
Price down, volume up, open interest up – bearish
Price down, volume up, open interest down – no effect

Several important points need to be made about futures volume:

• Futures exchanges do not report volume figures until the next day, so it is not very timely information.

• Futures volume is usually portrayed on charts as the composite volume for all contracts of that market and not just the contract month shown on the chart.

• Volume is related to pain and volatility, but it doesn’t necessarily mean they go hand in hand. The more pain traders are in as losses mount, the more likely they are to jump out of positions, and the more volatile the market is likely to be. The wider the price range, the more stops are hit, producing more volume. However, in futures that have daily price limits, it is possible for a market to have locked limit up or down moves with little or no volume.

• For every excited new buyer who wants to be long in futures, there must be a seller who wants to be short, meaning that volume and open interest figures may have little predictive value. The key is the quality of the volume. Who is buying, and who is selling to cause the volume? That leads to another area of analysis.

• Futures have no limit on volume or how many contracts can be open. The numbers diminish as expiration of a contract nears, a process that itself can have a bearing on prices.

Next week: Channeling price energy