can miss thetrend, but might enter the trade on the wrong side. Buy/sell signals are usuallygenerated when the price crosses through the entire band. One usually uses this technique when looking for a market about to establish a trend.Exponentially weighted moving averages give more weight to the most recentprices during a specified period.Differentials between moving averages also can be used to identify cycles.
MOVING AVERAGE OSCILLATORSThe term oscillator usually means simply the difference between two moving averages. For example, when the oscillator crosses the zero line, it simply means twomoving averages have crossed. Traders use oscillators as indicators of overbought/oversold conditions and initiate trades when the oscillator reaches a certainextreme positive or extreme negative. Sometimes people combine the oscillator witha moving average of the oscillator! Thus, overbought/oversold signals come whenthe moving average of the oscillator crosses the oscillator; i.e., long positions aretaken on upward crossovers, short positions on downward crossovers.An increasingly popular oscillator is an exponential moving average of theoscillator. This is often referred to as the MACD or moving average convergence divergence. The oscillator is based on the exponential moving averages and the movingaverage of the oscillator is also exponential. Crossover rules are the same as for any
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of the moving average techniques. Most traders use the MACD for finding divergence,and combine this technique with other overbought/oversold indicators.
A SURVEY OF TECHNICAL INDICATORSAs noted previously, many technical indicators are derived from other technical indicators—singles or groups. Almost all of the technical indicators make use of, orincorporate, the basic forecasting tools discussed in Chapter 10, i.e., ratios, indexnumbers, correlations, moving averages, etc. The purpose of this section is to survey in summary fashion the list of technical indicators most commonly used bytraders. This list is not exhaustive, but should motivate the reader to select a fewof these indicators for further study.TECHNICALINDICATORS
BRIEFDESCRIPTION
1. Accumulation/Distribution
This is an index designed to identify changesin major trends. Accumulation/distributionstudies are designed to search for divergenceswithin the market characteristics that mightbe indicative of potential trend changes, e.g.,a confluence of indicators that suggests smartbuyers are gradually running out of steam andare “distributing” their activity to protect theirgains and establish short positions, or indications suggesting that smart traders are gradually accumulating a position on the long sideof the market in anticipation that a bull market is about to emerge.The running index is composed byadding or subtracting portions of daily pricemoves (adding for higher closes, subtractingfor lower closes) over some specified periodof time.
2. Directional MovementIndex (DMI)
The DMI is designed to measure the strengthof a trend by measuring the increase in volatility as reflected in the increases (not thedecreases) in the daily trading true range overa 14-day period. The directional movement
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index is the creation of Welles Wilder, an engineer turned technical analyst. It is actually acombination of three separate rate indicators—an average directional index (ADX), upwardmovement (+DI), and downward movement(–DI). The +DI measures the strength ofupward pressure, the –DI the strength ofdownward pressure, and the ADX, a ratio ofthe DMI averaged over 14 days, or the propensity for trending. The ADXR is a furtherrefinement of the ADX, resulting from another averaging process. The arithmetic for computing this index is quite cumbersome, thoughnot complex. Those interested should checkthe book by Welles Wilder called New Concepts in Technical Trading.3. Trading Bands
Bands are lines drawn at fixed intervals aboveand below a moving average. The interval isusually based on a measure of volatility (suchas a percentage), or one, or two, or three standard deviations above and below the average.The use of standard deviations rather than afixed percentage for the interval allows thebands to adjust for volatility as they change.During volatile periods, the bands move further away from the average. During quiet periods, they converge toward the average. Thecloser the prices move to the upper band, themore overbought the market is. The closerprices move to the lower band, the more oversold the market is.
4. Candlestick Chart
Candlestick charts are a very old tool developed in Japan and are very similar to a standard bar chart, with the exception that the distance between the open price on the bar andthe closing price on the bar is drawn hollow ifthe closing price is higher than the previousbar, and drawn solid if the closing price islower than the previous bar. Interpretations ofpatterns are similar to traditional U.S. inter124
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pretations of charts, though different namesare attached to the patterns.5. Commodity Channel Index
The commodity channel index was originallydesigned to detect the beginning and endingof cycles and important trends. The index, asit is normally constructed, incorporates a moving average together with a factor reflectingtrading ranges. The index is designed to capture about 80 percent of all price fluctuationbetween an index value of +100 and –100. Thegeneral trading rule is that when the indexexceeds 100, you establish a long position.When it falls below –100, you go short. Often,this indicator is used by traders as a measure ofoverbought/oversold. Its reliability is spotty.
6. Moving AverageConvergence/Divergence(MACD)
MACD is the difference between a fast exponential moving average and a slow exponential moving average. During rising markets,the fast moving average will rise more quickly than the slow, resulting in a rising value.During falling markets, the reverse will betrue. When the fast line crosses the slow linefrom below, it is a buy signal. When it crosses it from above, it is a sell signal.
7. Momentum Oscillator
Momentum (also called rate of change indicator) is another overbought/oversold indicator and is often referred to when people aretalking about an oscillator. Basically, amomentum indicator tells one whether pricesare rising or falling at an increasing or decreasing rate. It is usually calculated by simplyadding or subtracting the price changes fromone period to the next. So if the closing pricesare advancing by increasing amounts, momentum is up; if closing prices are advancing bydecreasing amounts from time period to timeperiod, momentum is down. When there is nochange in price, momentum is zero. Crossingthe zero line indicates an overbought/oversold125
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condition; hence, one buys when the indicatorpasses up through the line, and sells when itpasses down through it. As with other indicators, the time period chosen for analysis isimportant. Some experienced traders alsoclaim that one should match momentum cyclesto the underlying price cycle of the market.8. Moving Average Envelope
This refers to price bands placed a certain percentage above and below a simple movingaverage. As the market approaches the upperband, it is considered overbought. As itapproaches the lower band, it is consideredoversold.
9. Exponential MovingAverage
The exponential moving average is a form ofa weighted average in which each older priceis given less and less importance and the morerecent prices take on greater importance.Crossovers of the fast or slow exponentialmoving averages are used to provide buy andsell signals.
10. On Balance Volume(OBV)
On balance volume (OBV) is the creation ofJoe Granville, a well-publicized flamboyantstock market operator. OBV is very similar tothe accumulation/distribution technique discussed above, except that it is based on volume(not price), and was designed to try to uncover accumulation and distribution patterns oflarge stock traders. The OBV attempts togauge the buying and selling pressure on themarket by measuring the volume of tradingaccompanying any particular price bar. Thevolume associated with an up price move isconsidered indicative of buying pressure.Volume associated with a down price movement is representative of selling pressure. Overany given time period, the up volume and thedown volume are netted and the resultant differential compared to the price move. If theOBV moves down while the price goes up, it126
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signifies buying pressure is weakening. IfOBV moves up while the price moves down,it signifies selling pressure is weakening.Some traders find this a very useful tool, butfor it to be useful, one must have reliable dataon volume. Many futures markets display considerable inconsistency in the reporting ofdaily volume figures. There are even greaterproblems if one tries to apply this technique onintra-day trading where volume estimates arevery rough approximations.11. Parabolic System
The parabolic system was designed by WellesWilder to help traders identify points to exit themarket and reverse their positions. It alwayskeeps you in the market. A stop and reverse(SAR) price point is based upon an initialextreme price achieved in some immediatepast price movement. That SAR point is gradually increased at an increasing rate as timepasses. In a stop and reverse methodology,you liquidate a long position and establish ashort position, or you liquidate the short position and establish a long position. The systemconsiders time an important factor. So if aposition does not remain profitable as timepasses, it is reversed. Its success is dependenton the speed with which it adjusts the stop andreverse price.
12. Price Channel
The price channel, like price bands, is oftenused to detect breakouts of significant supportand resistance areas. A penetration of the upperchannel line is considered a sign of significantmarket strength. The penetration of the lowerchannel line is a sign of significant marketweakness. As prices approach the lower line,many traders look for buying opportunities,but immediately stop and reverse their positions if the prices break the line. They do theopposite when prices approach the upper band.
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13. Rate of Change
The rate of change indicator reflects the market’s price change as a percentage over someshort period of time. Many traders buy whenthe rate of change line crosses the zero linefrom below and sell when it crosses fromabove.
14. Relative Strength Index(RSI)
Another overbought/oversold indicator iscalled the relative strength index (RSI). TheRSI attempts to estimate the current strengthor weakness in the price movement during agiven period. The underlying assumption isthat higher closes indicate strong upward pricemovement, while lower closes indicate weaker prices. The RSI is simply an index of thedifference between the sum of all up closesand the sum of all down closes during someshort time period, usually nine or 14 tradingperiods, e.g., minutes, hours, days, weeks, etc.When the index on a 14-day RSI drops below30 or moves above 70, traders usually consider those to be indications of overbought oroversold extremes. If one were using a nineday RSI, the extreme levels would be 20 and80. Although this is a very popular indicator,one needs to be careful in the application ofthis technique. It is not unusual for RSIs toremain in overbought or oversold territory fordays or even weeks before a trend ends.
15. Range Leader
The range leader compares 50 percent of thetrading range to the high and the low price ofa given time period and weights the result bya volume differential. Range leader bars on abar chart are used to indicate impendingupward moves or downward moves.
16. Key Reversals
A key reversal buy signal is generated whenthe current period’s price low is below theprevious period’s low and the close is abovethe previous period’s close. The reverse is trueof a sell signal. These indicators give large128
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numbers of false signals and are most reliableonly when they are accompanied by very largevolume.17. Stochastics
A stochastic is an oscillator that indicates overbought/oversold conditions. It essentiallymeasures the frequency with which price closes tend to accumulate near either end of theprice bar on a bar chart; i.e., during periodsof price decreases, if the closes tend to accumulate near the low end of the bar, it is considered a bearish signal. The reverse is truefor price closes accumulating near the highend of the bar. Traders usually smooth thesecalculations by means of a moving averagetechnique and then create both fast and slowstochastic moving averages that generate twolines often called the percent K and the percentD lines. Traders use divergences between thelines as indications of overbought and oversold. They also consider the absolute levels tobe important trading signals. Divergencebetween the two is considered important whenthe percent D line makes a series of lowerhighs while the commodity price makes aseries of higher highs. This signals an overbought market. An oversold market occurswhen the commodity posts a series of lowerlows while the percent D makes a series ofhigher lows. Generally the buy/sell signals aregenerated when the percent K crosses the percent D. Most people use this indicator withgreat caution and then only in conjunctionwith major trend indicators.
A warning is in order on all of these technical indicators. None of them workwell all of the time. All of them work some of the time. All of them are very sensitive to the length of time selected for creating the indicator, i.e., a nine-day indicator will sometimes be more reliable than a 14-day indicator. Generally, all ofthem have a high incidence of false signals. A significant amount of research onthe MACD shows that the indicator isn’t very reliable, particularly in short swingmarkets.129
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The best trading opportunities arise when several of these indicators flash similar trading signals. Generally, the reliability of those signals increases if the systems are based on different parameters, sets of rules, assumptions, or information.For example, if the MACD, stochastic, RSI, momentum, and DMI are all neartheir extremes flashing buy signals, one should have more faith in the reliabilityof their signals and, therefore, more confidence in entering into trades.Application of these analytic tools based on different time windows can beextremely helpful in confirming or strengthening the reliability of signals. For example, if the monthly, weekly, daily, and hourly signals are all flashing the same witha set of these tools, one can have much greater confidence in establishing positions.In any event, these tools are all designed to provide guidance to traders searching for turning points in a trend. It is virtually impossible for a trader to pick exactturning points. The objective should be to take the middle out of the trend. Prudentuse of these technical tools and patience in waiting until a number of them flash thesame signals will increase enormously the probability that the trader will makemoney and capture significant portions of important price trends in most markets.
WARNINGMany technical indicators develop popularity because of the allure associated withtheir claims to success. However, as noted above, many of them are not successful when used independently of others. One has to remember these are indicators,not necessarily reliable signals. Many technical indicators provide a certain scientificpanache that some people use to generate sales of systems, excitement about trading, and commissions. To those people, whether the tools actually make money forthe investors is often secondary. More often, these technical indicators are very reliable as indicators of what has happened, but not very reliable as predictors of whatwill happen. In many cases, they can be more distractions than aids in dealing withthe problems of making money, especially if the tools encourage overtrading.These tools require the user to have considerable emotional aptitude in dealingwith the ups and downs of the market.
VolatilityThere are really two faces to volatility. Historical volatility allows one to developprobability distributions and provides a statistical estimate of how prices havetended to vary from the norm. Implied volatility, on the other hand, is an up-to-datereading of how current market participants view what is likely to happen. Impliedvolatilities are calculated from options prices (see Chapters 26 and 27).If the market has anticipated a piece of news such as a trade surplus figure ora political development, implied volatilities will tend to stay flat or decline, but if the130
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market has not anticipated the event, traders’ sense of surprise will be reflected in thesize of movement; implied volatility will rise accordingly. Implied volatility is mosteasily calculated from the options markets, but needs to be interpreted with some caution. Illiquid markets will send false signals about implied volatility.Changes in volatility often presage real market trends. For example, when amarket is trading into new high territory and well above some of the popular moving averages, price alone might not supply the most useful evidence about wherethe trend is headed. Knowledge of historical volatility measured in conjunctionwith price level and implied volatility can, however, be helpful. To illustrate, onewould expect that as markets move into higher ground, volatility also wouldincrease if the trend is expected to continue. But if the volatility remains stable whileprices climb, that’s significant evidence that the “market” believes the increasedactivity can be absorbed and the trend likely will be short-lived. A market withrapidly rising implied volatility, especially if it is reaching the outer edges of aprobability distribution curve, suggests that the market expects an advance to occurthat may cause a sustainable market change.Implied volatility also provides other information. For example, if a marketthat is trading slightly below the moving averages begins to fall, and if volatilitydrops sharply during that fall, it suggests that the market believed that whatevertriggered that fall already had been discounted. In general, increasing volatilityindicates prices will continue to move away from moving averages. Decreasingvolatility indicates a move toward moving averages.
Elliott WaveElliot Wave analysis is one of the more popular contemporary methodologies foranalyzing market price movements. It was popularized in the 1980s by RobertPrechter, who made consistently correct and very profitable calls on the stock market right up to and including the crash of 1987.The Elliott Wave Theory (EWT) emanates from research conducted in stocksby Ralph Elliott in the early 1930s. It was popularized in the 1960s in the writingsof A.J. Frost and by Frost and Robert Prechter in a book published in 1978.Essentially, EWT has three important components—chart patterns (calledwaves), ratios, and time cycles. The theory states that wave patterns come insequences of fives and threes—five waves in the direction of the major trend andthree waves in the direction of the correction of the major trend (see Figure 12.1).Each wave subdivides into similar five-and-three patterns in a continuingseries of waves of smaller and smaller degree and, as these subdivisions occur,their count forms a series of numbers called Fibonacci numbers.These wave formations take on traditional chart patterns familiar to technicalanalysts and similar to those discussed in the preceding chapters. Thus, by connecting the extreme points of the waves, one can see triangles, pennants, channels,131
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Figure 12.1 Elliott Wave Count Illustrated
5 stepmajor trend
5
3 stepminor trend3
5
32
4
4
1
1
1
Major Trend
23
2
rising and falling wedges, etc. These familiar patterns along with Fibonacci ratiosidentify areas of support and resistance and price objectives.
Fibonacci RatiosA Fibonacci sequence of numbers is 1,1, 2, 3, 5, 8, 13 . . . N. It is named after a13th century mathematician named Leonardo Fibonacci, whose statue stands nearthe Leaning Tower of Pisa in Italy. Fibonacci’s sequence represents the reproduction rate of rabbits (a problem he was trying to solve).All of that has very little to do with commodity trading except that the sequencehas some unique properties which seem to reflect price behavior in markets.First, the sum of any two consecutive numbers equals the next higher number; e.g., 1 + 1 = 2; 2 +3 = 5, etc.Second, the ratio of any number to its next higher number, after the first 4numbers, is approximately .618.Third, the ratio of any number to its next lower number is 1.618 or the inverseof .618.Fourth, the ratio of alternate numbers approaches 2.618 or its inverse of .382.These ratios, when combined with the wave counts, chart patterns, and timecycles yield an elaborate set of “rules” and high probability tendencies that givequite explicit guidance on when to enter a market, whether to be long or short,what price objectives to expect, both in the direction of the trend and the extent ofa correction, and in what time frame to expect such movements.The EWT model is complex and comprehensive. It attempts to pull together into an understandable package the many diverse elements and techniques of tra132
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ditional technical analysis, mathematical tendencies, and contemporary knowledge. Some analysts think it has a lot of elements in common with other marketmovement theories like the Dow Theory.In summary, according to the Elliott Wave Theory:➥ A complete bull (bear) market cycle is made up of eight waves, five up(down) waves followed by three down (up) waves.➥ A trend divides into five waves in the direction of the next longer trend.➥ Corrections always take place in three waves.➥ Waves can be expanded into longer waves and subdivided into shorterwaves. Sometimes one of the impulse waves extends. The other two shouldthen be equal in time and magnitude.➥ The Fibonacci sequence is the mathematical basis of the Elliot WaveTheory and the number of waves follows the Fibonacci sequence.➥ Fibonacci ratios and retracements are used to determine price objectives.The most common retracements are 62 percent, 50 percent, and 38 percent.➥ Its “rule of alternation” warns not to expect the same thing twice in succession.The Elliott Wave Theory is comprised of wave forms, ratios, and time, inthat order of importance. The theory was originally applied to stock market averages; does not work as well on individual stocks and many individual futures; andworks best in those commodity markets with the largest public following, such asgold, bonds, and Eurodollars.No one theory, however, holds all the answers. The Elliott Wave Theory isan excellent model to help get a perspective on a market, but long-term success intrading will be enhanced if you use it in conjunction with other tools. Using it inconjunction with all of the other technical theories in this book will increase its valueand improve your chances for success.
MIMICKING THE MIND—NEURAL NETWORKSOne of the most helpful computer tools ever invented was the spreadsheet. In fact,it was the development of Lotus 1-2-3 that really made personal computers popular. Spreadsheets also revolutionized investment analysis because they made number crunching easy.Neural networks (or computers that “learn”) are the next stage in the movetoward making computers mimic the human mind ever more perfectly and to mak133
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ing them more agile in deductive reasoning. Wall Street firms have spent tens ofmillions of dollars to design and adapt neural networks to replace human traders.Neural networks are systems of computer commands that are designed forprocessing huge amounts of information and data; seeking answers to basic questions concerning the data; interpreting those answers and remembering them; formulating new questions; interpreting those answers, etc., and then, after thousandsof iterations, distilling some meaning out of the data, facts, and information generated in the Q&A process.Because a computer, unlike a human, does not get bored, tired, forgetful,hungry, sleepy, etc., it can “mine” deeper into the information and data regardingpast events and their results and find patterns of price behavior that the humanmind will not find or recognize as important.Real neutral networks, as opposed to those that are simply dressed up assuch, have an “intuitive” approach to their answers to questions. This intuition iscalled fuzzy logic. Essentially, the computer makes good guesses of what the correct answer is when the correct answer is not clear-cut. This often leads it to explorerelationships that otherwise might not be explored. This fuzzy logic element makesneutral networks especially useful for processing imprecise information or information in which relationships are unknown. Figure 12.2 depicts a typical neutralnetwork process. The computer would start by searching for answers in the information sets I-V. Those answers would then be further refined by searching throughthe factors in group A, then group B, then group C and, finally a response wouldbe selected. So, for example, you may ask the computer to help you determinewhether, during the first quarter of a new presidency, the U.S. dollar will be strong
Figure 12.2 Neural Network Illustrated
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or weak, i.e., should you buy it or sell it? It would then search through the first setof factors, say, current economic status of the U.S., and arrive at a set of responses that need to be further refined by the next set of factors, say, foreign tradingpartners’ economic situations. This, in turn, will generate a set of responses to befurther refined or narrowed by the next set of factors, say, the technical marketindicators, then to chart pattern recognition, then to Elliott Wave Analysis, and soon, until it finally works its way through each set of questions and information,checking and back-checking its logic, and arrives at an answer, which could be, “Idon’t know!”For many years, neural networks have been applied in the military, especially by the Navy in its efforts to explore the oceans and detect submarines. Neural networks are part of the systems for guiding missiles and other high-tech weaponry.Recently, neutral networks have been packaged for sale to traders. Pricesrange from several hundred to several thousand dollars. Many of them work withspreadsheets like Excel.Before you buy a neural net system, there are several things you should keepin mind:1. Many of the computer systems sold as neural network systems are not.They are simply the same old “rule testing technical tools,” torturing andcurvefitting data without the “intuition” or fuzzy logic element.2. The data needs for operating a neural network will be immense.3. You have to train the neural network to recognize the correct answers tothe questions you have asked it to research. You have to train it to fit yourproblem, feed it lots of facts about the past events and their results, giveit time to learn to distinguish correct answers from incorrect answers againand again, and give it time to learn from the mistakesit makes.4. The old adage about computers—garbage in, garbage out— applies hereas well. If you don’t train it on good reliable data and with sound logic,it will give you back “bad answers.”5. A good neural network, after it has completed its training, will probablyregularly tell you it does not know the answer and cannot give you specific guidance about a particular problem. In other words, it can be just asconfused as you in trying to distill meaning out of the gobs of information available in the marketplace. In such cases, it should tell you to stayout of the market.6. Neural networks can be trained to fit your biases. The frequency, and thusthe accuracy, of neural network forecasts can be adjusted to suit your comfort level. If you like trading action, you can set the neural network’s135
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parameters and train it to give you short-run recommendations, many ofwhich may be wrong. If you want only long-term, high-probability trades,you can train it accordingly.7. Neural networks can make a substantial contribution to your trading analysis by helping you identify the factors that are most important in influencingthe neural network’s “thoughts” at any point in time. In that sense, evenif you don’t follow its advice exactly, it may greatly enhance and supplement your “human analytic ability.”Lastly, the major difference between neural networks and regression analysis, a commonly used statistical method for examining data, is that regressionanalysis averages all past influences and data and assumes they are about the sametoday. A neural network, on the other hand, understands that under different market conditions, different factors will have different weights. It keeps learning fromits experience and from its mistakes. Thus, as the market changes, its thoughtschange and it searches through its memory to find similar situations that emergedin previous periods to discern what the most likely result will be. It then makes its“best guess.”
ADDITIONAL REFERENCESFollowing is a list of some references on technical analysis for additional study:Bernstein, Jacob. 1982. The Handbook of Commodity Cycles: A Window on Time,New York: Wiley.Edwards, Robert D. and John Magee. 1966. Technical Analysis of Stock Trends, 5thedition, Boston, MA: John Magee.Frost, Alfred J. and Robert R. Prechter. 1978. Elliott Wave Principle, Key to StockMarket Profits. Chappaqua, NY: New Classics Library.Kaufman, Perry J. 1978. Commodity Trading Systems and Methods. New York:Wiley.Kaufman, Perry J. 1980. Technical Analysis in Commodities. New York: Wiley.Pring, Martin. 1985. Technical Analysis Explained, 2nd edition, New York:McGraw-Hill.Schwager, Jack D. 1984. A Complete Guide to the Futures Markets: FundamentalAnalysis, Technical Analysis, Trading, Spreads, and Options. New York:Wiley.
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Teweles, Richard J., Charles V. Harlow, and Herbert L. Stone. 1974. The CommodityFutures Game—Who Wins?—Who Loses?—Why?, 2nd edition. New York:McGraw-Hill.
FUTURES PERIODICALSFutures, The Magazine of Commodities and Options, 219 Parkade, Cedar Falls, IA50613.
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Chapter 13
Volume and Open Interest
Two important elements of technical analysis are the daily trading volume andopen interest.Technical analysts would no more think about ignoring the statistics on volume and open interest than they would consider eating their breakfast eggs without salt and pepper. Volume and open interest statistics are, in a sense, seasonings.When mixed with the other information available, they heighten the sense of what’shappening in the market.When we speak of volume of trading, we are referring to the total of purchasesor of sales, not of purchases and sales combined. That is, each time a transactionis completed—whether it involves the establishment of a new position or an offset of an old position—the volume is increased by one.“Open interest” refers to futures contracts that have been entered into and notyet liquidated by an offsetting transaction or fulfilled by delivery. As with volume, the open interest figure is for one side of the market only, not for the long andshort sides combined. However, unlike volume, the effect of a transaction upon openinterest does depend on whether new positions are being established or old onesclosed out.139Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
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When trading in a new delivery month begins, there are no contracts in existence, so the open interest is zero. This is in contrast to the stock market, where anew issue may begin trading with many shares available for trading prior to itsopening. In the futures market, a new contract comes into existence only when anew buyer and a new seller complete a transaction. If the buyer is offsetting by buying back a previously sold contract or the seller is offsetting by selling a previouslypurchased contract, there is no change in the open interest.Thus, the rules for determining changes in open interest are as follows:1. Open interest increases only when a new contract is made, i.e., a new purchase is matched with a new sale.2. Open interest decreases when an old purchase is liquidated by a sale andthe opposite side of the transaction is an old seller buying back his previous short position.3. Open interest decreases when a short makes a delivery on a contract anda long accepts delivery.4. There is no change in open interest when a new purchase is matched withan offsetting transaction (sale of a previous purchase) or if a new sale ismatched with an offsetting transaction (purchase of a previous sale).All open contracts must ultimately be closed out in one of three ways: by anoffsetting transaction; by making or taking delivery of the physical commodity; orby cash settlement at maturity.And, if all this has started the fog horns blowing, maybe an example willhelp. Let’s assume that you now