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Figure 7.5 The first half of this chart shows a positive trend with heaviervolume on up days. The box at the top shows a sudden downturn on heavyvolume—a negative sign. Notice the increase in trading as the continuationtriangle is broken on the downside.
 
 
 
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 Volume and Open Interest 165
 
the mere fact that prices are trending higher, we can see that thereis more buying than selling pressure. It stands to reason then thatthe greater volume should take place in the same direction as theprevailing trend. Technicians believe that volume precedes price,meaning that the loss of upside pressure in an uptrend or down-side pressure in a downtrend actually shows up in the volume fig-ures before it is manifested in a reversal of the price trend.
On Balance Volume
Technicians have experimented with many volume indicators tohelp quantify buying or selling pressure. Trying to “eyeball” thevertical volume bars along the bottom of the chart is not alwaysprecise enough to detect significant shifts in the volume flow.The simplest and best known of these volume indicators is onbalance volume or OBV. Developed and popularized by JosephGranville in his 1963 book, Granville’s New Key to Stock MarketProfits, OBV actually produces a curving line on the price chart.This line can be used either to confirm the quality of the currentprice trend or warn of an impending reversal by diverging fromthe price action.
Figure 7.6 shows the price chart with the OBV line alongthe bottom of the chart instead of the volume bars. Notice howmuch easier it is to follow the volume trend with the OBV line.
The construction of the OBV line is simplicity itself. Thetotal volume for each day is assigned a plus or minus valuedepending on whether prices close higher or lower for that day. Ahigher close causes the volume for that day to be given a plusvalue, while a lower close counts for negative volume. A runningcumulative total is then maintained by adding or subtracting eachday’s volume based on the direction of the market close.
It is the direction of the OBV line (its trend) that is impor-tant and not the actual numbers themselves. The actual OBV val-ues will differ depending on how far back you are charting. Letthe computer handle the calculations. Concentrate on the direc-tion of the OBV line.
The on balance volume line should follow in the same direc-tion as the price trend. If prices show a series of higher peaks and166 Chapter 7
 
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Figure 7.6 = The line along the bottom shows on balance volume (OBV)for the same Compag chart. Notice how much easier it was to spot thedownturn in October 1997.
troughs (an uptrend), the OBV line should do the same. If pricesare trending lower, so should the OBV line. It’s when the volumeline fails to move in the same direction as prices that a divergenceexists and warns of a possible trend reversal.
Alternatives to OBV
The on balance volume line does its job reasonably well, but it hassome shortcomings. For one thing, it assigns an entire day's vol-ume a plus or minus value. Suppose a market closes up on the dayby some minimal amount such as one or two tics. Is it reasonableto assign all of that day’s activity a positive value? Or consider asituation where the market spends most of the day on the upside,but then closes slightly lower. Should all of that day’s volume beVolume and Open interest 167
given a negative value? To resolve these questions, technicianshave experimented with many variations of OBV in an attempt todiscover the true upside and downside volume.
One variation is to give greater weight to those dayswhere the trend is the strongest. On an up day, for example, thevolume is multiplied by the amount of the price gain. Thistechnique still assigns positive and negative values, but givesgreater weight to those days with greater price movement andreduces the impact of those days where the actual price changeis minimal.
There are more sophisticated formulas that blend volume(and open interest) with price action. James Sibbet’s DemandIndex, for example, combines price and volume into a leadingmarket indicator. The Herrick Payoff Index uses open interest tomeasure money flow. (See Appendix A for an explanation of bothindicators.)
It should be noted that volume reporting in the stock mar-ket is much more useful than in the futures markets. Stock trad-ing volume is reported immediately, while it is reported a day latefor futures. Levels of upside and downside volume are also avail-able for stocks, but not in futures. The availability of volume datafor stocks on each price change during the day has facilitated aneven more advanced indicator called Money Flow, developed byLaszlo Birinyi, Jr. This real-time version of OBV tracks the level ofvolume on each price change in order to determine if money isflowing into or out of a stock. This sophisticated calculation, how-ever, requires a lot of computer power and isn’t readily availableto most traders.
These more sophisticated variations of OBV have basical-ly the same intent—to determine whether the heavier volume istaking place on the upside (bullish) or the downside (bearish).Even with its simplicity, the OBV line still does a pretty good jobof tracking the volume flow in a market—either in futures orstocks. And OBV is readily available on most charting software.Most charting packages even allow you to plot the OBV line rightover the price data for even easier comparison. (See Figures 7.7and 7.8.)168 Chapter 7
 
0124/97 (INTC) Intel Corp
 
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Figure 7.7 An excellent example of how a bearish divergence between theon balance volume line (bottom) and the price of Intel correctly warned of amajor downturn.
Other Volume Limitations in Futures
We've already mentioned the problem of the one day lag inreporting futures volume. There is also the relatively awkwardpractice of using total volume numbers to analyze individual con-tracts instead of each contract’s actual volume. There are goodreasons for using total volume. But how does one deal with situa-tions when some contracts close higher and others lower in thesame futures market on the same day? Limit days produce otherproblems. Days when markets are locked limit up usually producevery light volume. This is a sign of strength as the numbers ofbuyers so overwhelm the sellers that prices reach the maximumtrading limit and cease trading. According to the traditional rulesof interpretation, light volume on a rally is bearish. The light vol-ume on limit days is a violation of that principle and can distortOBV numbers.Volume and Open Interest 169
 
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Figure 7.8 Overlaying the OBV (solid line) right over the price barsmakes for easier comparison between price and volume. This chart ofMcDonalds shows the OBV line leading the price higher and warning inadvance of the bullish breakout.
Even with these limitations, however, volume analysis canstill be used in the futures markets, and the technical trader wouldbe well advised to keep a watchful eye on volume indications.
INTERPRETATION OF OPENINTEREST IN FUTURES
The rules for interpreting open interest changes are similar tothose for volume, but require additional explanation.
1. With prices advancing in an uptrend and total open inter-est increasing, new money is flowing into the market reflectingaggressive new buying, and is considered bullish. (See Figure7.9.)170 Chapter 7
 
[11/11/97 (AMO0398) Sitver 03/98
 
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Figure 7.9 The uptrend in silver prices was confirmed by a similar rise inthe open interest line. The boxes to the right show some normal liquidationof outstanding contracts as prices start to correct downward.
2. If, however, prices are rising and open interest declines, therally is being caused primarily by short covering (holders of los-ing short positions being forced to cover those positions).Money is leaving rather than entering the market. This action isconsidered bearish because the uptrend will probably runout of steam once the necessary short covering has beencompleted. (See Figure 7.10.)
3. With prices in a downtrend and open interest rising, thetechnician knows that new money is flowing into the market,reflecting aggressive new short selling. This action increasesthe odds that the downtrend will continue and is consid-ered bearish. (See Figure 7.11.)
4. If, however, total open interest is declining along withdeclining prices, the price decline is being caused by discour-Volume and Open interest 171
 
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Figure 7.10 An example of a weak price rebound in gold futures. Theprice rise is accompanied by falling open interest, while the price declineshows rising open interest. A strong trend would see open interest trendingwith price, not against it.
aged or losing longs being forced to liquidate their positions.This action is believed to indicate a strengthening technicalsituation because the downtrend will probably end onceopen interest has declined sufficiently to show that mostlosing longs have completed their selling.
Let’s summarize these four points:
. Rising open interest in an uptrend is bullish.
. Declining open interest in an uptrend is bearish.. Rising open interest in a downtrend is bearish.
. Declining open interest in a downtrend is bullish.
PWN172 Chapter 7
 
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Figure 7.11 The downturn in copper during the summer of 1997 and thesubsequent price decline was accompanied by rising open interest. Risingopen interest during a price decline is bearish because it reflects aggressiveshort selling.
Other Situations Where Open InterestIs Important
In addition to the preceding tendencies, there are other marketsituations where a study of open interest can prove useful.
1. Toward the end of major market moves, where openinterest has been increasing throughout the price trend, a levelingoff or decline in open interest is often an early warning of a change intrend.
2. A high open interest figure at market tops can be consideredbearish if the price drop is very sudden. This means that all of thenew longs established near the end of the uptrend now have los-ing positions. Their forced liquidation will keep prices under pres-sure until the open interest has declined sufficiently. As an exam-Volume and Open Interest 173
ple, let’s assume that an uptrend has been in effect for some time.Over the past month, open interest has increased noticeably.Remember that every new open interest contract has one newlong and one new short. Suddenly, prices begin to drop sharplyand fall below the lowest price set over the past month. Every sin-gle new long established during that month now has a loss.
The forced liquidation of those longs keeps prices underpressure until they have all been liquidated. Worse still, their forcedselling often begins to feed on itself and, as prices are pushed evenlower, causes additional margin selling by other longs and intensi-fies the new price decline. As a corollary to the preceding point, anunusually high open interest in a bull market is a danger signal.
3. If open interest builds up noticeably during a sideways con-solidation or a horizontal trading range, the ensuing price move inten-sifies once the breakout occurs. This only stands to reason. The mar-ket is in a period of indecision. No one is sure which direction thetrend breakout will take. The increase in open interest, however,tells us that a lot of traders are taking positions in anticipation ofthe breakout. Once that breakout does occur, a lot of traders aregoing to be caught on the wrong side of the market.
Let’s assume we’ve had a three month trading range andthat the open interest has jumped by 10,000 contracts. Thismeans that 10,000 new long positions and 10,000 new short posi-tions have been taken. Prices then break out on the upside andnew three month highs are established. Because prices are tradingat the highest point in three months, every single short position(all 10,000 of them) initiated during the previous three monthsnow shows a loss. The scramble to cover those losing shorts nat-urally causes additional upside pressure on prices, producing evenmore panic. Prices remain strong until all or most of those 10,000short positions have been offset by buying into the marketstrength. If the breakout had been to the downside, then it wouldhave been the longs doing the scrambling.
The early stage of any new trend immediately following abreakout is usually fueled by forced liquidation by those caughton the wrong side of the market. The more traders caught on thewrong side (manifested in the high open interest), the moresevere the response to a sudden adverse market move. On a more174 Chapter 7
positive note, the new trend is further aided by those on the rightside of the market whose judgment has been vindicated, and whoare now using accumulated paper profits to finance additionalpositions. It can be seen why the greater the increase in open interestduring a trading range (or any price formation for that matter), thegreater the potential for the subsequent price move.
4. Increasing open interest at the completion of a price patternis viewed as added confirmation of a reliable trend signal. The break-ing of the neckline, for example, of a head and shoulders bottom ismore convincing if the breakout occurs on increasing open inter-est along with the heavier volume. The analyst has to be carefulhere. Because the impetus following the initial trend signal isoften caused by those on the wrong side of the market, sometimesthe open interest dips slightly at the beginning of a new trend. This ini-tial dip in the open interest can mislead the unwary chart reader,and argues against focusing too much attention on the openinterest changes over the very short term.
SUMMARY OF VOLUME AND OPENINTEREST RULES
Let’s summarize some of the more important elements of price,volume, and open interest.
1. Volume is used in all markets; open interest mainly infutures.
2. Only the total volume and open interest are used for futures.
3. Increasing volume (and open interest) indicate that thecurrent price trend will probably continue.
4. Declining volume (and open interest) suggest that theprice trend may be changing.
5. Volume precedes price. Changes in buying or selling pres-sure are often detected in volume before price.
6. On balance volume (OBV), or some variation thereof, canbe used to more accurately measure the direction of vol-ume pressure.Volume and Open Interest 175
7. Within an uptrend, a sudden leveling off or decline inopen interest often warns of a change in trend. (Thisapplies only to futures.)
8. Very high open interest at market tops is dangerous andcan intensify downside pressure. (This applies only tofutures.)
9. A buildup in open interest during consolidation periodsintensifies the ensuing breakout. (This applies only tofutures.)
10. Increases in volume (and open interest) help confirm theresolution of price patterns or any other significant chartdevelopments that signal the beginning of a new trend.
BLOWOFEFS ANDSELLING CLIMAXES
One final situation not covered so far that deserves mention is thetype of dramatic market action that often takes place at tops andbottoms—blowoffs and selling climaxes. Blowoffs occur at majormarket tops and selling climaxes at bottoms. In futures, blowoffsare often accompanied by a drop in open interest during the finalrally. In the case of a blowoff at market tops, prices suddenlybegin to rally sharply after a long advance, accompanied by alarge jump in trading activity and then peak abruptly. (See Figure7.12.) In a selling climax bottom, prices suddenly drop sharply onheavy trading activity and rebound as quickly. (Refer back toFigure 4.22c.)
COMMITMENTS OFTRADERS REPORT
Our treatment of open interest would not be complete withoutmentioning the Commitments of Traders (COT) Report, and how itis used by futures technicians as a forecasting tool. The report isreleased by the Commodity Futures Trading Commission (CFTC)twice amonth—a mid-month report and one at month’s end. The176 Chapter 7
 
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Figure 7.12 A couple of blowoff tops in coffee futures. In both cases,prices rallied sharply on heavy volume. The negative warnings came from thedecline in open interest (solid line) during both rallies (see arrows).
report breaks down the open interest numbers into three cate-gories—large hedgers, large speculators, and small traders. Thelarge hedgers, also called commercials, use the futures marketsprimarily for hedging purposes. Large speculators include thelarge commodity funds, who rely primarily on mechanical trend-following systems. The final category of small traders includes thegeneral public, who trade in much smaller amounts.
WATCH THE COMMERCIALS
The guiding principle in analyzing the Commitments Report isthe belief that the large commercial hedgers are usually right,while the traders are usually wrong. That being the case, the ideais to place yourself in the same positions as the hedgers and in theopposite positions of the two categories of traders. For example, aVolume and Open Interest 177
 
bullish signal at a market bottom would occur when the com-mercials are heavily net long while the large and small traders areheavily net short. In a rising market, a warning signal of a possi-ble top would take place when the large and small traders becomeheavily net long at the same time that the commercials arebecoming heavily net short.
NET TRADER POSITIONS
It is possible to chart the trends of the three market groups, and touse those trends to spot extremes in their positions. One way to dothat is to study the net trader positions published in Futures Charts(Published by Commodity Trend Service, PO Box 32309, PalmBeach Gardens, FL 33420). That charting service plots three linesthat show the net trader positions for all three groups on a weeklyprice chart for each market going back four years. By providingfour years of data, historical comparisons are easily done. Nick VanNice, the publisher of that chart service, looks for situations wherethe commercials are at one extreme, and the two categories oftraders at the other, to find buying and selling opportunities (asshown in Figures 7.13 and 7.14). Even if you don’t use the COTReport as a primary input in your trading decisions, it’s not a badidea to keep an eye on what those three groups are doing.
OPEN INTEREST IN OPTIONS
Our coverage of open interest has concentrated on the futuresmarkets. Open interest plays an important role in options tradingas well. Open interest figures are published each day for put andcall options on futures markets, stock averages, industry indexes,and individual stocks. While open interest in options may not beinterpreted in exactly the same way as in futures, it tells us essen-tially the same thing—where the interest is and the liquidity.Some option traders compare call open interest (bulls) to put openinterest (bears) in order to measure market sentiment. Others useoption volume.178 Chapter 7
 
Large Net LongCommercial Positions
  
Figure 7.13 This weekly chart of S&P 500 futures shows three buy sig-nals (see arrows). The lines along the bottom show the commercials (solidline) heavily net long and the large speculators (dashed line) heavily netshort at each buy signal.
PUT/CALL RATIOS
Volume figures for the options markets are used essentially thesame way as in futures and stocks—that is, they tell us the degreeof buying or selling pressure in a given market. Volume figures inoptions are broken down into call volume (bullish) and put volume(bearish). By monitoring the volume in calls versus puts, we areable to determine the degree of bullishness or bearishness in a mar-ket. One of the primary uses of volume data in options trading isthe construction of put/call volume ratios. When options tradersare bullish, call volume exceeds put volume and the put/call ratiofalls. A bearish attitude is reflected in heavier put volume and ahigher put/call ratio. The put/call ratio is usually viewed as a con-trary indicator. A very high ratio signals an oversold market. A verylow ratio is a negative warning of an overbought market.Volume and Open Interest 179
 
 
COPPER - WEEKLY‘Nearest Futurea Contract aa of Friday’s CloeaCooptge 1007 CTA Franc Ramairg
 
 
 
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Figure 7.14 This weekly chart of copper futures shows three sell signalsmarked by the arrows. Each sell signal shows net long positions by the twocategories of speculators and a net short position by the commercials. Thecommercials were right.
COMBINE OPTION SENTIMENTWITH TECHNICALS
Options traders use open interest and volume put/call figures todetermine extremes in bullish or bearish sentiment. These senti-ment readings work best when combined with technical measuressuch as support, resistance, and the trend of the underlying mar-ket. Since timing is so crucial in options, most option traders aretechnically oriented.
CONCLUSION
That concludes our coverage of volume and open interest, at leastfor now. Volume analysis is used in all financial markets—futures,180 Chapter 7
 
options, and stocks. Open interest applies only to futures andoptions. But, since futures and options are traded on so manystock market vehicles, some understanding of how open interestworks can be useful in all three financial arenas. In most of ourdiscussions so far, we've concentrated on daily bar charts. Thenext step is to broaden our time horizon and to learn how toapply the tools we’ve learned to weekly and monthly charts inorder to perform long range trend analysis. We'll accomplish thatin the next chapter. 
INTRODUCTION
Of all the charts utilized by the market technician for forecastingand trading the financial markets, the daily bar chart is by far themost popular. The daily bar chart usually covers a period of only sixto nine months, However, because most traders confine their inter-est to relatively short term market action, daily bar charts havegained wide acceptance as the primary working tool of the chartist.
The average trader’s dependence on these daily charts,however, and the preoccupation with short term market behavior,cause many to overlook a very useful and rewarding area of pricecharting—the use of weekly and monthly charts for longer range trendanalysis and forecasting.
The daily bar chart covers a relatively short period of timein the life of any market. A thorough trend analysis of a market,however, should include some consideration of how the dailymarket price is moving in relation to its long range trend struc-ture. To accomplish that task, longer range charts must be employed.Whereas on the daily bar chart each bar represents one day’s price
181182 Chapter 8
action, on the weekly and monthly charts each price bar repre-sents one week’s and one month’s price action, respectively. Thepurpose of weekly and monthly charts is to compress price action insuch a way that the time horizon can be greatly expanded and muchlonger time periods can be studied.
THE IMPORTANCE OF LONGERRANGE PERSPECTIVE
Long range price charts provide a perspective on the market trend thatis impossible to achieve with the use of daily charts alone. During ourintroduction to the technical philosophy in Chapter 1, it waspointed out that one of the greatest advantages of chart analysisis the application of its principles to virtually any time dimension,including long range forecasting. We also addressed the fallacy,espoused by some, that technical analysis should be limited toshort term “timing” with longer range forecasting left to the fun-damental analyst.
The accompanying charts will demonstrate that the prin-ciples of technical analysis—including trend analysis, support andresistance levels, trendlines, percentage retracements, and pricepatterns—lend themselves quite well to the analysis of long rangeprice movements. Anyone who is not consulting these longer rangecharts is missing an enormous amount of valuable price information.
CONSTRUCTION OFCONTINUATION CHARTSFOR FUTURES
The average futures contract has a trading life of about a year anda half before expiration. This limited life feature poses some obvi-ous problems for the technician interested in constructing a longrange chart going back several years. Stock market techniciansdon’t have this problem. Charts are readily available for individ-ual common stocks and the market averages from the inceptionof trading. How then does the futures technician construct longerrange charts for contracts that are constantly expiring?Long Term Charts 183
The answer is the continuation chart. Notice the emphasison the word “continuation.” The technique most commonlyemployed is simply to link a number of contracts together toprovide continuity. When one contract expires, another one isused. In order to accomplish this, the simplest method, and theone used by most chart services, is to always use the price of thenearest expiring contract. When that nearest expiring contractstops trading, the next in line becomes the nearest contract andis the one plotted.
Other Ways to ConstructContinuation Charts
The technique of linking prices of the nearest expiring contractsis relatively simple and does solve the problem of providing pricecontinuity. However, there are some problems with that method.Sometimes the expiring contract may be trading at a significantpremium or discount to the next contract, and the changeover tothe new contract may cause a sudden price drop or jump on thechart. Another potential distortion is the extreme volatility expe-rienced by some spot contracts just before expiration.
Futures technicians have devised many ways to deal withthese occasional distortions. Some will stop plotting the nearestcontract a month or two before it expires to avoid the volatility inthe spot month. Others will avoid using the nearest contract alto-gether and will instead chart the second or third contract.Another method is to chart the contract with the highest openinterest on the theory that that delivery month is the truest rep-resentation of market value.
Continuation charts can also be constructed by linkingspecific calendar months. For example, a November soybeancontinuation chart would combine only the historic data pro-vided by each successive year’s November soybean contract. (Thistechnique of linking specific delivery months was favored byW.D. Gann.) Some chartists go even further by averaging theprices of several contracts, or constructing indices that attemptto smooth the changeover by making adjustments in the pricepremium or discount.184 Chapter 8
 
THE PERPETUAL CONTRACT™
An innovative solution to the problem of price continuity wasdeveloped by Robert Pelletier, president of Commodity Systems,Inc., a commodity and stock data service (CSI. 200 W. PalmettoPark Road, Boca Raton, FL 33422), called the Perpetual Contract.™(‘Perpetual Contract™ ” is a registered trademark of that firm.)
The purpose of the Perpetual Contract™ is to provide yearsof futures price history in one continuous time series. That isaccomplished by constructing a time series based on a constantforward time period. For example, the series would determine avalue three months or six months into the future. The time peri-od varies and can be chosen by the user. The Perpetual Contract™is constructed by taking a weighted average of two futures con-tracts that surround the time period desired.
The value for the Perpetual Contract™ is not an actualprice, but a weighted average of two other prices. The main advan-tage of the Perpetual Contract™ is that it eliminates the need forusing only the nearest expiring contract and smoothes out theprice series by eliminating the distortions that can take place dur-ing the transition between delivery months. For chart analysis pur-poses, the nearest-month continuation charts published by chartservices are more than adequate. A continuous price series, how-ever, is more useful for back-testing trading systems and indicators.A more complete explanation of ways to construct continuousfutures contracts is provided by Greg Morris in Appendix D.
LONG TERM TRENDS DISPUTERANDOMNESS
The most striking features of long range charts is that not only aretrends very clearly defined, but that long range trends often last foryears. Imagine making a forecast based on one of these long rangetrends, and not having to change that forecast for several years!The persistence of long range trends raises another inter-esting question that should be mentioned—the question of ran-domness. While technical analysts do not subscribe to the theorythat market action is random and unpredictable, it seems safe toLong Term Charts 185
observe that whatever randomness does exist in price action isprobably a phenomenon of the very short term. The persistence ofexisting trends over long periods of time, in many cases for years, is acompelling argument against the claims of Random Walk Theoriststhat prices are serially independent and that past price action has noeffect on future price action.
PATTERNS ON CHARTS: WEEKLYAND MONTHLY REVERSALS
Price patterns appear on the long range charts, which are inter-preted in the same way as on the daily charts. Double tops and bot-toms are very prominent on these charts, as are head and shoul-der reversals. Triangles, which are usually continuation patterns,are frequently seen.
Another pattern that occurs quite frequently on thesecharts is the weekly and monthly reversal. For example, on themonthly chart, a new monthly high followed by a close below theprevious month’s close often represents a significant turningpoint, especially if it occurs near a major support or resistancearea. Weekly reversals are quite frequent on the weekly charts.These patterns are the equivalent of the key reversal day on thedaily charts, except that on the long range charts these reversalscarry a great deal more significance.
LONG TERM TO SHORTTERM CHARTS
It’s especially important to appreciate the order in which price chartsshould be studied in performing a thorough trend analysis. Theproper order to follow in chart analysis is to begin with the longrange and gradually work to the near term. The