When it has been a lot of days if not weeks of falling stocks or index, we do look for a relief. These come in naturally most of the times. Some of the sellers may book profit near the pivotal levels and the fall just halts.
However, when there is a sequence of such fall and tiny comebacks or consolidations, there comes a time when we see signs of selling being overdone. The biggest indicator of such development is of course, the price movement.
Imagine, a stock went down from 100 to 80 in step wise sequence of falls and tiny comebacks or consolidations. The last fall started from 83 to 80. After hitting 80 though there was a comeback. This comeback or a respite or relief from the recent fall takes it to 84. This is above the recent breakdown point.
This is when we are posed with the question if this comeback up move should be termed as a Respite or a Reversal from the fall that started from the level of 100. To answer this question, we need to ask ourselves one more question.
What kind of commitment level is with those who bought into this recent up move?
Commitment can be easily termed as bias that one would have, while trading any price move. Apparently, futures trading activity gives a solid insight that can throw a light on the consensus bias. All we need to do is, look at the open interest.
What is Open Interest?
Since Futures and Options are derivatives in other words instruments created out of stock or indices, they do not have any physical reference points. A Buyer and a Seller of a Futures or Options Contract creates one position. This position is called 1 Open Interest.
Since there is no physical reference point, we all know that we can Sell Futures first if we are bearish and then when it comes down, we can buy it back.
Alternatively, just like equity we can Buy Futures first and Sell it after when it rises if our bias is Bullish.
The reason for this explanation is that the rise in price when compared with the rise or fall in Open Interest, will be able to give us indication of consensus bias.
Price Rise + Futures Open Interest Rise = Bullish Bias (Traders are taking First Buy Trade)
Price Fall + Futures Open Interest Rise = Bearish Bias (Traders are taking First Sell Trade)
Price Fall + Futures Open Interest Fall = Bulls Neutralizing Bias (Byers are Booking Profit)
Price Rise + Futures Open Interest Fall = Bears Neutralizing Bias (Sellers are Booking Profit) a.k.a. Short Covering
Look at the 4 combinations once again. We can find that 2 things can happen with Rise in Price, Open Interest can Rise or Fall.
For us to get an indication of is this a Respite or Reversal all we need to see is that with
Price Rise + Open Interest Rise
This means the up move is not just an infamous “Short Covering Rally”.
Just one day’s observation may not do the job of giving a confident reading. However, over a period of time if we see price keeping up with the rise and open interest too keeping up a rise with it. We can at least start bargain hunting.
Data of Open Interest is easily available over the internet or in any Option Analytics application.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.