Trade breakouts better by tracking trade data

Indices have been either staying in a small range or have been rising. As a result, after closing at an all-time high last year we are additionally up by around 15 percent. This gives a good problem to deal with. The problem is to validate the breakout. I feel the best way to help get confidence in a rise to an extent is when we have validation.

One of the best guides to validate whether the current rise will be sustained or not is by using the Trade Data of Open Interest. Let us understand what OPEN INTEREST is first and then figure out how can it help in boosting our validation.

OPEN INTEREST is nothing, but the number of contracts open in a particular instrument. Futures contracts are fictitious (not tangible like equities). To measure its total population, one needs to create some sort of accounting. This accounting is called OPEN INTEREST. One Buyer + One Seller create One contract = One OPEN INTEREST.

Now, let us see how OPEN INTEREST can help us validate that the move could sustain and extend. We all know that Price has most of the information about the sentiment and can tell the bias. However, when we put the OPEN INTEREST up and down alongside the Price move in the Future contract, we get to know something extra.

If the OPEN INTEREST is going up means more Buyers and Sellers are creating fresh positions into trading that Futures or Options contract. If OPEN INTEREST is going down that means traders are exiting the Futures or Options contract.

Now let us add a Price change to this. Even though the contract is created by a new Buyer and new Seller coming together, we need to know that between the two one has weaker bargaining power than the other.

Now if a Buyer has weaker bargaining power they will Buy at an even higher price. Similarly, if a Seller has weaker bargaining power they will Sell at a lower Price.

The reason behind this is when you are expecting Rs 1000 stock to go up to Rs 1100 you are ok paying 1010 but would want to enter before it’s too late. Similarly, when you are expecting Rs 1000 stock to fall to Rs 900 you want to Sell it as early as possible even though it means selling at Rs 990.

Thus, we establish that Weaker Bargaining power has an insight on what is the expectation of the price movement.

Coming back to how this can help us trade breakouts better. Imagine we have an all-time high being made. At the same time, if the Open Interest is also making at least a monthly high, your breakout passes the validation test.

At the same time, if the Future price is making newer highs but the Open Interest is making newer lows, avoid. This does not pass the validation, because price is going up, but traders are exiting.

Open Interest data is easily available on the Futures chart on most of the Options analytics/charting platforms.