Stock Market: How Volume And Open Interest Can Help You Improve Your Stock Market Trading?

Relationship of Volume And Open Interest With Price In The Stock Market

Mastery over the interpretation of their action is of paramount importance to the art and science of forecasting potential price activity in the stock markets.

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Although the price is regarded as the best indicator of potential future price behavior, volume and open interest offer additional evidence to corroborate bullish or bearish setups.

Together they can indicate potential underlying weakness and also function as timing indicators for potential breakouts. 


Let’s look at below simple definition of the volume:


VOLUME: Number of entities traded during the time period under study. (or) Total amount of trading activity in the market of that day.


RE-READ POINTS BELOW:


  1. The level of volume measures the intensity or urgency behind the price move.

  2. Heavier volume reflects a higher degree of intensity or pressure.

  3. By monitoring the level of volume along with the price action, the technician is better able to gauge the buying or selling pressure behind the market moves.

  4. This information can then be used to confirm price movement, or warn that price move is not to be trusted.


Volume Convergence And Divergence


Divergence concept is worth putting in the time and concentration. Because it helps us to catch the reversals early in the stock market.


Please understand the statements below:

  • Volume divergence occurs whenever volume declines, irrespective of the direction of price.
  • Volume convergence or confirmation occurs whenever volume rises, irrespective of the direction of price.

Now, based on the above two statements and below four illustrations, try to understand the below statements. Re-read it multiple times if you want to, but understand it fully.


  1. Whenever volume and price are declining together, we have bullish divergence.

  2. Whenever volume and price are rising together, we have bullish confirmation(or convergence).

  1. Whenever volume is declining and price rising, we have bearish divergence.

  2. Whenever volume is rising and price declining, we have bearish confirmation(or convergence).


To make this volume thing more clear, let’s have a look at the below illustrations:


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There are different definitions(Divergence) of these four scenarios, but I don’t want to make anyone confused.

I am simply putting it, WE DONT WANT ABOVE; WE WANT BELOW TO TRADE SUCCESSFULLY IN THE STOCK MARKET.


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Another important topic with volume is the use of volume oscillators on the charts. I recommend you to use a non-price-based oscillator.


Price‐based volume oscillators include:

  1. On Balance Volume (OBV)

  2. Accumulation/Distribution Line (ADL)

  3. Demand Index


Non-price-based volume oscillators include:

  1. Standard Volume Bars

  2. Smoothed Volume

  3. Detrended Volume

  4. Rate of Change of Volume (ROC Volume)

  5. Percentage Volume Oscillator (PVO)


I use Standard Volume Bars on my chart. We need to use a secondary indicator that thinks/works differently than price action, that is, non-price based.


Here are the four possible scenarios for a top and bottom with respect to volume:


1. A market top associated with extreme volume is called a blow‐off or buying climax.

2. A market bottom associated with extreme volume is called a sell‐off or selling climax.

3. A market top associated with extremely low or minimal volume is called a low volume top.

4. A market bottom associated with extremely low volume is called a low volume bottom.


Volume To Price Relationship


Although considered old school, it is vital to learn this relationship in stock market trading or stock market investing.


If you are a stock market beginner, please pay close attention to below explanation.


Let's have a look at the below illustration and an explanation of it to understand how movement in volume affects the price movement.


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1. Narrow range on low volume(Low Volume Rest Bar): Indicates a potential for reversal especially during a strong and rapid up or downtrend. For weak to average trends, it tends to indicate a point of rest. It reflects a lack of participation. See Example 1


2. Narrow range on high volume(High Volume Reversal Bar): Indicates a strong potential for a reversal. In an uptrend, price remains confined to a narrow range on very large volume. If the volume represented buying pressure, the range would be much wider. Hence, this is indicative of sellers attempting to take control. It is a bearish signal. The converse applies for downtrends. See Example 2


3. Wide range on low volume(Low Volume Reversal Bar): Indicates a potential for reversal as the large price move was backed or supported by a relatively low amount of participation. It reflects a lack of interest. The longer the price bar on low volume, the more bearish it is in an uptrend and bullish in a downtrend. See Example 3


4. Wide range on high volume(High Volume Continuation Bar): Indicates a potential for continuation as the large price move was backed and supported by a very large amount of participation, that is, interest in seeing price continue. It is bullish in an uptrend and bearish in a downtrend. See Example 4

My Observations About Volume

Below are my personal observations regarding VOLUME in the stock market. The first observation is what my strategy based upon, super important and it works.


  1. **VOLUME PRECEEDS PRICE**


  1. BY MONITORING PRICE AND VOLUME TOGETHER WE ARE ACTUALLY USING TWO DIFFERENT TOOLS TO MEASURE EXACT SAME THING - PRESSURE !


  1. LOSS OF UPSIDE PRESSURE IN UPTREND OR DOWNSIDE PRESSURE IN DOWNTREND WILL BE FIRST DISPLAYED BY VOLUME.

 

  1. **VOLUME CAPTURES THE POSITIONS OF SMART MONEY(HEDGE FUND MANAGERS, INVESTMENT BANKS, MUTUAL FUNDS).


What Is Open Interest?


OI: Total number of outstanding/unliquidated contracts at the end of the day. For every long, there will be a short so we count only one side total.


Open interest is simply the total amount of outstanding contracts in the futures and options markets. Unlike stocks, all futures and options contracts eventually expire


Open interest is therefore the number of unliquidated long or short contracts. Each contract consists of a long and corresponding short position.


Open interest increases when a new long and corresponding short position are initiated, and decreases when both the long and corresponding short position are exited.


1 Long Contract and 1 Short Contract = 1 Open Interest


1 Buy and 1 Sell = 1 Volume(cumulative volume is total trades for that stock for that time)


**Open interest remains unchanged(unlike volume) when either the long or short position is replaced by a new position, but not both at the same time.


Generally speaking, open interest is interpreted the same way as volume.


Below is the interpretation of price and open interest:


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Below is the interpretation of price and volume:

Stock-Market-How-Volume-And-Open-Interest-Can-Help-You-Improve-Your-Stock-Market-Trading

When prices, volume, and open interest are all rising, this is indicative of a bullish market, predominantly driven by buying pressure. 


Conversely, when prices are rising but both volume and open interest are declining, this is indicative of a bearish market, predominantly driven by shorts covering their positions and longs leaving the market. 


Traders In Stock Market With Respect To Volume & Open Interest

 

As far as stock market trading is concerned a trader should look for appropriate buy signals when price, open interest, and volume are all rising. Conversely, a trader should look for a suitable exit in order to liquidate long positions if rising prices are accompanied by declining open interest and volume.

 

In a declining market, traders should look for appropriate signals to go short if both the open interest and volume are rising, and rapidly seek to cover all short positions when both the open interest and volume start to decline together.


It should be noted that the level of open interest may be indicative of the nature of a potential reversal or breakout. For example, if open interest is very high, the ensuing reversal may be significantly more rapid, due to the large number of open contracts liquidating and covering.


Stock market beginners must observe and study these terms first in the market.


Book Alert:


Learn to Earn: A Beginner's Guide to the Basics of Investing and Business

-BY PETER LYNCH


KEY TAKEAWAYS

  • VOLUME PRECEDES PRICE
  • Use non-price-based volume oscillators with the price(candlestick).
  • Unusually HIGH Open Interest in a Bull Market is often a dangerous signal.
  • Greater the increase in OI in a trading range, the greater the potential for the subsequent price move.
  • FOLLOW THE SMART MONEY.


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