Key takeaways
- Open interest refers to the total number of outstanding contracts that haven’t been settled, while trading volume measures the total number of contracts traded within a specific timeframe.
- Increasing open interest typically signals the entry of fresh capital, indicating stronger market trends, whereas high trading volume indicates active participation and liquidity.
- Analyzing open interest and trading volume together can reveal various market scenarios, such as high open interest with low volume indicating indecision, or high volume with declining open interest suggesting trend exhaustion.
- While open interest and trading volume are valuable metrics, they have limitations, including being lagging indicators and subject to market noise. Using them alongside technical indicators and price action offers better insights.
Open interest and trading volume are two metrics you often encounter while exploring the cryptocurrency market. Both metrics provide different perspectives on the cryptocurrency markets in a specific time period. The capability to analyze and interpret them enables you to make trading decisions more intelligently.
This article will explain what metrics like open interest and trading volume mean for crypto traders, how they differ, the limitations of these metrics and how to collectively decode market returns using open interest and trading volume.
What is open interest?
Open interest is a term you often hear when discussing futures or derivatives trading in crypto. But what exactly is open interest? To put it simply, open interest is the total number of outstanding options contracts held at a given time that have not yet been exercised, expired or closed.
Calculating open interest is a simple process. Open interest rises by one each time a buyer and a seller draft a new agreement. Open interest declines when that contract is closed or settled by both parties. As the number of open contracts increases, open interest also rises.
You can close your positions either by taking the opposite position or exercising your option. Open interest increases when more new contracts are opened, than closed in a given day.
For example, consider an ABC call option that initially has no open interest:
Open interest provides you with information about the mood of the market. For instance, increasing open interest signals stronger trends since it indicates fresh capital entering the market. Conversely, a decrease in open interest may indicate a deteriorating trend if it implies that positions are being closed.
Did you know? During Bitcoin's 2021 bull run, open interest in Bitcoin futures exceeded $27 billion across major exchanges like Binance and CME, highlighting massive trader participation.
What open interest indicates to crypto traders
As a crypto trader, you can use open interest in several ways:
- Identify potential support and resistance levels: Open interest analysis helps identify potential support and resistance levels for options contracts. High open interest at specific strike prices suggests strong trader commitment, which can hinder price movements in either direction.
- Create hedging strategies: You use open interest data to create hedging strategies that mitigate the risk of unfavorable price movements in your portfolios.
- Spot opportunities: Open interest helps in identifying profitable opportunities. Contracts with high open interest and volume attract more traders due to associated liquidity and potential price impact.
What is trading volume?
Trading volume measures the total number of contracts or shares traded within a specific timeframe, typically a single trading day. It reflects the level of activity and liquidity in the market.
In the stock market, trading volume indicates the frequency of share exchanges. For crypto options markets, it measures the quantity of options contracts bought or sold during a day, regardless of whether they're opening or closing transactions.
Here’s an example to explain trading volume.
What trading volume indicates to crypto traders
You could use trading volume to get some insights regarding the options contracts:
- Volatility measurement: A sharp rise in daily trade volume often signals increased market volatility. This is particularly evident when major news or events trigger buying or selling activities in options contracts.
- Historical comparison: Analyzing current trade volume against past levels offers insights into the crypto market. It helps assess whether present volumes are unusually high or low compared to historical averages.
- Institutional activity: Significant trading volumes often indicate the involvement of institutional investors. These investors tend to follow the strategies and opinions of professional traders regarding the future price direction of the underlying asset.
- Verification of price movements: When combined with price analysis and other technical indicators, volume analysis assists in finding trends and chart patterns. For example, rising prices accompanied by increasing volume suggest a bullish signal, whereas a price rise with decreasing volume may raise doubts about the trend's strength.
Did you know? Open interest in Ethereum futures surged to $8 billion during the lead-up to the Ethereum 2.0 upgrade, indicating heightened anticipation in the derivatives market.
Open interest vs trading volume
In cryptocurrency markets, open interest and trading volume are two crucial metrics that provide useful perspectives on the behavior of the market. Open interest represents the number of contracts committed to open positions in derivatives markets. An increase in open interest usually indicates the entry of fresh capital into the market.
Trading volume, on the other hand, counts all trades made during a given time frame. A high trading volume usually means that the market is more active and liquid, which may cause price volatility as more people purchase and sell assets.
Open interest vs trading volume: Various scenarios
By analyzing open interest and trading volume together, you can identify market strength, predict trend continuations or reversals and make more informed trading decisions:
High open interest with low trading volume
A scenario with high open interest with low trading volume will occur if a large number of futures or options remain open over time, but the number of trades every day is low. For instance, if a crypto futures contract has 5,000 open positions but only 80 trades are executed on any given day, it indicates high open interest but low trading volume.
When traders hold onto their positions, anticipating a major market movement, and fewer new trades are initiated, it can indicate indecision about future events. This situation may lead to a potential price breakthrough.
High trading volume with declining open interest
A decrease in open interest with high trading volume can often occur when closing out futures or options positions.
Suppose a cryptocurrency, like ETH, has futures contracts with significant trading activity, around 40,000 trades happening in a day, but open interest goes down from 18,000 to 15,000 contracts. This suggests that many traders are closing their positions rather than opening new ones. This scenario possibly signals the end of a trend or profit-taking after a large price movement.
High open interest and high trading volume
High open interest and trading volume in crypto often occur during periods of intense market activity, like major news events or significant price movements. For example, during the 2021 bull run of BTC, both open interest and trading volume for Bitcoin futures contracts surged.
If there are 80,000 open positions and 70,000 contracts are traded on the same day, it indicates strong market participation. This suggests that many traders are holding existing positions and actively entering new trades, indicating a bullish momentum.
Low open interest and low low trading volume
When both open interest and trading volume are low in the crypto market, it suggests a lack of participation and interest. This often indicates a period of consolidation or indecision, with prices moving sideways.
Low open interest and trading volume indicate low volatility in the market prices of crypto and market apathy on the part of traders. However, any new information or events may trigger a major price movement.
You should analyze open interest and trading volume in conjunction with price action. A combination of rising prices with increasing open interest and volume gives a bullish signal and strong market momentum. Falling prices along with falling open interest and trading suggest a bearish signal.
Did you know? Crypto traders use open interest and trading volume to identify bullish or bearish trends. Rising prices with increasing open interest and volume often indicate strong upward momentum.
Limitations of using open interest and trading volume
When using open interest and trading volume for analyzing crypto markets, you should be aware of some challenges and limitations. While these metrics do provide useful insights, they are not foolproof indicators.
- Not always clear-cut: Sometimes, high open interest and trading volume may create an impression that a significant price change is about to occur, but nothing of the sort happens. Markets can be unpredictable, and traders might be holding positions for different reasons rather than trends.
- Lagging indicators: Trading volume and open interest are lagging indicators, which means they indicate past events rather than future ones. The market may have moved by the time you see a shift in these measurements.
- No prediction of direction: Trading volume and open interest indicate the amount of activity currently, but don't signal whether the market will move higher or lower. You'll need to use additional tools such as price action or technical indicators to determine whether the market carries bullish or bearish momentum.
- Exchange-specific data: Trading volume and open interest may differ greatly through various exchanges. As crypto is decentralized, the figures you're looking at may not accurately reflect the entire market, unlike traditional finance.
- Market noise: In the cryptocurrency space, abrupt increases in volume or open interest may result from noise, such as a whale (large investor) closing a position or making a sizable trade. You’ll be mistaken in picking cues from such erroneous signals.
Open interest and trade volume are helpful, but they should always be used in conjunction with technical indicators and price action to draw more decisive conclusions.
Decoding market patterns: Open interest and trading volume
Combining open interest and trade volume with technical indicators and price patterns provides a more comprehensive picture of market patterns. You get a better understanding of prevalent market sentiment, which assists you in planning your trades.
You could improve your trading tactics by identifying opportunities and steering clear of possible pitfalls. Understanding how these indicators work together may help guide your decisions when trading.
Exchanges like Binance have their own data dashboards where you can track these metrics. To get broader market insights, you can use platforms like TradingView, which not only provide you with customizable charts but also let you overlay volume indicators for a more detailed view.
This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.