Open Interest Interpretation: A Two-step simple hack to check trend strength of your position!

Why it is so important, often, when the market is in a correction, three out of four stocks follow the market direction

Traders are like intrepid seekers, driven by the market's daily moves, searching for the next big trend. But the real challenge lies in answering the ultimate question: To be in the market or not to be? After all, today's promising move may not continue its momentum tomorrow.

Cracking the code of a trend's lifespan and continuity involves a variety of studies, but luckily, they all rely on one potent weapon - Futures Open Interest (OI) data. With this information at hand, we gain the confidence to judge whether the current move has the strength to prevail.

Before we unveil the power of Futures OI, let's revisit four crucial inferences derived from Futures OI in relation to Price:

- Futures OI Up + Price Up = Long = Bullish Bias

- Futures OI Up + Price Down = Short = Bearish Bias

- Futures OI Down + Price Down = Long Unwinding = Bullish to Neutral

- Futures OI Down + Price Up = Short Covering = Bearish to Neutral

As you can see, focusing solely on Price movements can be misleading when interpreting the data.

Step No: 1

Now, before we explore whether to carry forward today's Price-driven trade, we must first check if the overall market supports our chosen direction. Because, it’s important to read the overall market direction. Why it is so important, often, when the market is in a correction, three out of four stocks follow the market direction. The market's overall trend could either bolster or undermine our stock selection.

For Bullish Trades:

Ensure that 60 per cent or more of the stocks show either Longs or Long Unwinding, indicating an overall Positive Futures OI Breadth. Or the stock which you have selected belongs to a sector which is showing relative outperformance and is in leading quadrant (Green) of Relative Rotation Graphs (RRG Charts).

For Bearish Trades:

Ensure that 60 per cent or more of the stocks show either Shorts or Shorts Short Covering, indicating an overall Negative Futures OI Breadth.

Of course, I won't tell you that a trade is entirely off the table if these conditions don't align. In such cases where a bullish trade is intended in a bearish market, one must review it meticulously.

Step No- 2

The four Price + OI signs taught us that not all up moves signify an incremental bullish bias in a stock. So, it becomes crucial to verify that the Price move we want to ride is accompanied by a rise in Futures OI. Here's why:

Traders always seek fresh trading opportunities when entering a stock. An increase in OI indicates incremental participation, which translates to a Price move up or down.

Hence, one of the most crucial factors:

Ensure that OI is Up along with Price Up or Down in the stock we intend to trade and carry forward.

On the other hand, Long Unwinding or Short Covering caused by a reduction in OI indicates that existing traders are exiting the market. This leaves us uncertain about whether the move will continue or fizzle out. Such scenarios are interpreted as Neutralizing OI activity.

In conclusion, a simple OI filter becomes our invaluable tool to differentiate potential trend-setters from mere one-day wonders.

So, fellow traders, as you embark on your trading journey, remember this wisdom and master the art of riding trends with precision and confidence!