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By Kenneth H. Shaleen
Interpreting volume and open interest statistics has always been important to technical analysis in the futures markets. Prior to the introduction of financial futures in 1972, agricultural products were the dominant futures traded. The life cycles of the commodities are associated with seasonal factors that cannot be overlooked.
For many years, the Commodity Research Bureau has compiled graphs revealing seasonal patterns in futures volume and open interest. The most recent update encompasses the 10-year period from 1979-1988. Included for the first time are seasonal studies of financial instrument futures, such as the interest rate and foreign exchange contracts. Does seasonality exist in those markets? If so, how does a technician use the information? This article will examine some of the technical ramifications, especially for the more recently introduced financial futures.
Volume - The number of futures contracts traded during each trading session. Buy volume always equals sell volume. Published volume figures represent one side only. Volume is a measure of urgency.
Open Interest - The summation of all unclosed purchases or sales at the end of a trading session. Long open interest always equals short open interest. Published open interest figures represent one side only. Open interest provides fuel to sustain a price trend.
Traditional Technical Analysis
Volume and open interest changes are used by technicians to measure the health of a price trend. The generally accepted rule is:
Volume and open interest should increase as prices move in the direction of the major price trend.
The two ideal conditions are shown in Figures 1. and 2. Note that total volume and total open interest readings are used; an examination of individual contract month figures contains severe limitations. The application of the general rule is also subject to considerable interpretation. Rarely does any market conform exactly to the "rules."
The CRB seasonal graphs of open interest and volume are constructed on a percentage scale. The absolute level of open interest is different from year to year, but the percentage changes do exhibit a regular pattern. These trends are very pronounced in the agricultural futures. Note the dramatic increase in open interest of corn and soybeans, as the size of the crop becomes more assured and the fall harvest in the U.S. approaches. This reflects the increased need to place hedges by both the producer and user of the commodity. For corn and soybeans, the study of the 10-year period ending in 1988 yields a high correlation with earlier studies in the mid-1950s.
The change in open interest is the important condition monitored by technical analysts. In its most minute application, the open interest change from one trading session to the next is analyzed in conjunction with the price change that session. But if the analysis is expanded to encompass several weeks, the seasonal influences in the traditional commodity futures must be factored in.
For example, given a price uptrend on a chart, if the open interest is declining, a weak price uptrend is deemed to be in effect. But what if total open interest normally declines at that time of year? A second step in the analysis is necessary. The following question must be answered: Is the current decline in open interest equal to or greater than what would normally be expected? If so, the same conclusions would be reached. But, if current open interest is only falling slightly in the face of an expected severe seasonal open interest decline, a more bullish reading of the current price rally would result. The percentage scale on the historic charts makes the comparison possible. A current 12 percent decrease in open interest from month to month compared to a normally expected 15 percent decrease is actually a net effective increase of 3 percent!
The CRB has made the task of analyzing seasonal factors easier by including a graphic history of open interest for the previous six years on the daily charts. This provides a quick and easy visual comparison showing the effective net change.
Although volume also exhibits seasonal characteristics, variations in volume are more important in day-to-day comparisons than over extended periods. Thus no seasonal adjustment is necessary. Volume on a daily basis is categorized as "high," "average," or "low." The reading is then analyzed in conjunction with the price change to determine the direction of the major price trend. For example, low volume sell-offs are bullish; low volume rallies are bearish.
Financial Instrument Futures
There is one distinct difference between the look of seasonal patterns of the agricultural commodities and the financial instruments. This is the tendency for the contract specifications of the financial futures to overwhelm any seasonal influences. Only the dominant calendar year-end effect of the financials is evident. The individual traits of several specific markets will be examined.
Open interest is very consistent in registering relative highs in the month prior to the quarterly expirations in March, June, September, and December. This can be attributed to three factors. First, options on T-bond futures expire in the month prior to the futures expiration; futures open interest most often shows a decline when an option series expires. Secondly, T-bonds are a physical delivery futures contract; positions are offset prior to the date actual delivery could occur (on the first day of the expiration month). Also, those months correspond with the Treasury's quarterly refunding cycle, when dealer hedging would be expected to increase.
A definite year-end phenomenon in T-bonds is observable. Omen interest tends to decline into year-end as book-squaring occurs. Another situation on the T-bond seasonal chart needs an explanation. A general escalation of open interest from April onward is evident. Some of the open interest increase was probably due to positions being placed solely to achieve a favorable position with respect to the U.S. income tax laws. Tax spreading was prevalent prior to its abolishment in 1982, but it should not be a factor today. Removing this aspect of tax spreading from seasonal studies is specifically addressed in the gold comment.
Eurodollar Time Deposits
A definite increase in open interest from mid-January to mid-December is observable on the seasonal chart. But some care must be taken not to read too much into this apparent yearly trend. Eurodollars began trading on the IMM in Chicago in December 1981. The CRB Eurodollar seasonal chart begins with the first full year of trading (1982) and contains only seven years of observation. Much of what appears to be a yearly trend is due to the phenomenal growth of the contract over time.
Of greater consequence in Eurodollars is the fact that the contract is cash settled. No onerous delivery mechanism (either for the longs or shorts) exists. Thus open positions in both futures and options can be held to the last trading day. Expiration occurs later than the 15th day of each quarter. The CRB seasonal graphs are plotted as of the 15th and the end of each month. Therefore, it is not surprising to see relatively low open interest at the end of the quarterly expiration months.
The most important technical factor concerning any cash-settled futures contract is the tendency for open interest to drop precipitously at the simultaneous expiration of the futures and options.
A change in the seasonal pattern of gold open interest has occurred since 1982. It is due to the curtailing of tax spreads. Open trade profits and losses are now marked to market (realized) at the end of each calendar year. Seasonal studies prior to 1982 showed a precipitous decline of open interest at the beginning of the calendar year, which extended to mid-year, and was followed by a distinct escalation into year-end. The month of May was the last chance for traders to place positions that had the possibility of "long term" (6+ months on long positions) capital gains (taxed at a lower rate) in the current calendar year. Open interest often increased in May. This was true for any storable cornmodity with relatively stable carrying-charge relationships.
The current CRB seasonal study of gold begins in 1984 (after tax spreads were ruled illegal) and extends to 1989 to produce an unbiased view. Note that the previously discussed seasonal variation in open interest is not present. A relative low in both trading volume and open interest occurs at the beginning of August (summer doldrums?). But in general, no dramatic seasonal influence is present such that an in-depth secondary level of analysis is needed. The contract month of June tends to be a popular vehicle with speculators. The seasonal study does indicate an escalation of open interest into mid-May, which then declines into first delivery day, June 1.
The remaining relative lows in open interest in COMEX gold futures are due to the expiration of the popular contract months of February, April, June, August, October, and December.
Relative lows in open interest are registered in mid-January and then at the end of the quarterly expiration months of March, June, and September. The D-mark seasonal study, in particular, shows that the relative peaks and troughs in open interest are about equal in percentage terms. The month of December is one of the lowest in terms of volume in all of the IMM foreign exchange futures.
These observations can again be explained in terms of the contract specifications. Of all the futures contracts, the currencies show the greatest amount of deliveries in relation to the total number of contracts outstanding. This is because arbitrage dealing between the cash inter-bank market and futures is unwound using the futures settlement process. The last trading day on the IMM is typically the third Monday of each calendar quarter. Delivery takes place two days later.
Options on currency futures expire early in the quarterly expiration month. After the options expiration, futures open interest declines. Looking at open interest on a single day at the end of the quarter (as the CRB does), one, of course, sees the decline from both the futures and options expirations.
Seasonal analysis is required for an accurate technical assessment of open interest in the traditional agricultural commodity futures. Many of the distinct variations in open interest in financial futures can be explained in terms of the contract specifications. In this regard, the technical analyst must be aware of any changes or innovations in the contract terms that would produce a discernible volume or open interest pattern. An example is the introduction of serial (monthly) options expirations. If the serial options become popular, a smaller cycle in open interest changes within a calendar quarter may become a new "seasonal" force.
Editor's Note: Additional insights into interpretation of volume and open interest are available in Mr. Shaleen's book, Volume and Open Interest: Cutting Edged Trading Strategies in the Futures Markets, Probus Publishing, 1991, Chicago.
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