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Price Scales, Volume and Open Interest

Price Scales

Just one more note about prices on charts for the moment. The charts above are shown, as you might expect, with an evenly spaced price scale on the left. This means that the distance from 4600 to 4800 is the same as the distance from 5400 to 5600, just 200 units. This usually works fine when you’re looking at short-term trading, but there is a choice that you have that can help with some longer term charts. You can use what is called a “logarithmic price scale”. On a logarithmic price scale, if you move the same distance vertically from one price to another, then you increase the price by the same ratio, and not by the same number.

For example, on a logarithmic price scale the vertical distance between 10 and 20 would be the same as the distance between 50 and 100, or 500 and 1,000 – the ratio in this case is 1:2. This makes more difference when you’re looking over a timescale of many years, which you might do to see the overall trends. If a price goes from 10 to 20 it is obviously much more important than if the price goes from 110 to 120, as it is 100% increase compared to about 9% increase, but with the way the charts above are drawn, using an “arithmetic price scale”, it would look the same. The logarithmic price scale would show that difference. Again, the whole thing is drawn for you so you don’t need to worry too much, but just know there is a choice if you want to explore it.

Don’t Forget Volume

I really mean that. Many traders get fixated on prices and the patterns that the candlesticks can make. This is another large field of study, but candlestick patterns on their own are no basis for making a trade. Steve Nison himself is at pains to emphasize that, warning traders that they must look at the big picture to know what the market is doing. Part of that big picture is the amount of trading volume. At the start of technical analysis, with Charles Dow, volume was considered an important confirmation of the trend. It’s no less important nowadays despite the invention of many other technical indicators that you can put on a chart.

The basic point is that if no one is trading, then the price you see is not generally accepted by the market. It’s almost like voting for the price. So with a low volume, you can see prices going in different directions and interpret them how you like, but they may not have much meaning. As soon as the market in general starts taking an interest you might find a price going off in a totally different direction.

Whatever you are trading, barring Forex, there is a sound basis for the volume figures. On stock markets and futures markets, where the volume is the number of contracts bought and sold, there is a good record of the number of transactions and how large they were. You run into a little difficulty if you are spread betting on the Forex market because no one knows exactly at the time how many transactions occur every day – there are just so many foreign exchanges around the world. This doesn’t stop there being estimates of the business, and you may have heard they say that the Forex market trades more than £2 trillion per day.

Volume is usually shown as above, drawn underneath the price chart with vertical bars. We’ll talk more about volume, together with associated indicators, later. For the present it’s sufficient to note that if there is a lot of volume on a particular day you need to pay close attention to it and what it might be telling you.

Open Interest

For those of you who are interested in futures and options, and spread betting on these markets, a brief discussion about the third factor that we know about those financial instruments. This is called open interest, and is a simple gauge of the interest in contracts, as opposed to the actual goods. If you have no desire to trade in these derivatives and don’t want to know about them, then you can skip this subheading.
Futures are usually associated with commodities, or physical products, although you can have futures contracts on other securities, such as shares. The futures contract is simply a commitment to buy or sell at a certain price on a set date, and to keep them tradable the amount and quality of the commodity is predefined, and the date is pre-set for each month, though sometimes months are missed out. The standardization means that there are futures markets where these contracts are easily bought and sold.

With that preamble out the way, open interest is a count of all the outstanding futures (or option) contracts. It is a running total of the contracts, and thus is different from a daily count of volume. It shows how much interest in general there is in trading the commodity on that month. For every futures contract there is a person who takes the buying position, and someone who takes the selling position, as if the contract ran to the end date the commodity would be bought and sold per contract. This means that there are two traders to a contract – open interest counts them as one.

Because they’re not trading physical goods, but just a promise, there are actually three ways that futures contracts can be developed. You see, futures contracts are traded all the time and seldom go up to the end date with the original buyer and seller. You don’t need to worry about this, because that’s what the futures markets are for, but it does have an effect on open interest.

If there are two traders, fresh to the market, one buying and one selling the futures contract then the open interest would increase by one, as a new contract has been taken out. Similarly, if there are two traders, one who has previously bought the contract and one who has previously sold, who both want to liquidate their positions or get out of the contract, when they do so it will reduce the open interest by one contract – there will be one less futures contract in existence. Or you might have the intermediate position, where one trader wants out of a contract when a new trader is looking to buy one, and that makes no difference to the open interest numbers – effectively the new trader is taking over the contract from the old one.

So open interest won’t necessarily go up or down by the daily trading volume, because it will depend on the traders involved. All we know is that the open interest cannot go up or down by more than the daily trading volume. Open interest is not so straightforward as trading volume, but it is still an important indicator if you’re in those markets. For instance, if open interest is increasing in an uptrend then you can reasonably know that more contracts are being written, and with more traders taking part it tends to confirm whatever trend is in place. But you can be caught out by this common knowledge if there isn’t an established trend, but simply a sideways market, as the increased number of contracts may mean more commercial interests are taking out a short position, expecting a crash.

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