The recurrence of certain behaviour patterns at price extremes is most fortunate. We know from long experience of the financial markets what these behaviour patterns are like. So if we can gauge them, we can in theory perform a continuous diagnosis of the market, by locating its fluctuations all the way up the time scale from days through weeks and months to years. In practice we are limited by the availability of hard data: for instance some data exist on a daily basis, some only weekly, but most only irregularly.

Currency Bulletin uses four gauges of sentiment, which are designed to help identify these price extremes which are also extremes of consensus and speculation. They are:

1) IMM* open interest

2) The consensus

3) Perception of the trend

4) Reaction to news.

Two of the 4 sentiment gauges – the consensus gauge and the open interest gauge – are supposed to locate extremes in consensus and speculation, hence peaks and troughs in the dollar. They are used in a contrarian manner. They are early warning indicators which tell us to cut back exposures or

eliminate them. The other two – reaction to news and perception of trend – aim to tell us when the correction or reversal has started, i.e. the moment when it is appropriate to open positions in the opposite direction.

Speculation and activity can be measured statistically in the IMM. For sure, the IMM accounts for a very small fraction of activity in the world’s forex* markets. Yet, as explained, it is significant out of all proportion to its relative size, because it is a distillate of speculative activity around the globe; and it excludes the “froth” of the interbank clearing process. The open interest* is effectively speculative interest. The IMM open interest is simply the number of contracts open at the end of the day on the Chicago exchange. The theoretical problem with this is that for every buyer there is a seller. This apparent problem disappears if you consider that the trader who wishes to trade is never refused. For every deal there is an initiator, and the counter party always shows up.

Traders, as noted, can be divided into two categories: a) those who buy on a price rise and sell on a fall (‘price-led’* traders), and b) those who sell a rise and buy a fall (‘value-led’* traders). And in fact, the party we are looking for –the party whose action marks and indeed causes the extremes

of a price trend –is not just the speculator, but the ‘price-led’ speculator who buys the rise and sells the fall. They are the initiators of positions opened in the direction of the trend. We have our price extreme when the number of these parties peaks.

In real life, we find that the IMM open interest (01) tends to move faithfully in line with the perceived trend –as you can see from the charts here. It increases as the price trend progresses, and contracts whenever the trend is checked or corrected.

In the 01 figures, we are looking for an open interest rising in line with the trend to tell us when we have an increasingly overextended position. What happens when speculators think a trend has reversed? At that point the 01, which has been declining as the trend is seen to have been checked, begins to increase as the players change sides and begin to speculate on the new trend. So the 01 is giving you valuable information here. You have to decide which side you are on. If you think the original trend is intact, this is a signal to get ready to plunge on that side.

We can see these situations easily enough in retrospect. It’s not so easy before the event. Nobody said it was easy. But when the open interest gets above certain historical levels, we have a warning light. For example we could say the lights turn yellow when the open interest in the O-Mark gets above 80,000 and red when it gets above 90,000. We have to watch the other currencies contracts too. Sometimes the Swiss franc will give a warning signal –or the pound or the Yen. And sometimes the message only comes across when you take all the four major currency contracts together. For example, when traders are playing the non-dollar currencies against each other (the cross-rates*), the open interest numbers tend to get higher: we need to make a mental adjustment for this too. For example,

when there has been heavy cross-trading in the DM, the open interest has sometimes risen to 120,000, whereas otherwise 100,000 has represented an extreme in speculative interest.

NOTE. You have to make an automatic mental adjustment for those big drops you see in the open interest charts in March, June, September and December. IMM positions tend to concentrate in the earliest month, which is called “the front month “. As the contract month approaches maturity, margins are increased and many traders roll their position over into the next month. However, these positions are mostly taken on by members or locals on the floor of the exchange: so they do not tend to drop out of the overall open interest figures until the very final expiry of the contract, which is the Wednesday following the second Friday of the expiry month. That day often produces a sharp price movement, usually against the trend. See “open interest” in the Glossary.

Occasionally, a peak in daily activity or trading volume in the IMM contracts will mark the exact extreme of a trend, providing a valuable confirmatory indicator of the open interest pattern. Some examples can be seen in the Swiss Franc IMM chart in 1990. Such peaks come out of the blue, and if they happen to mark a price extreme, this is only apparent with hindsight. You get the same phenomenon in other financial and commodity markets. As a thermometer of price extremes it’s wise to use volume sparingly– and only in retrospect.

In the currency markets the open interest gauge is uniquely valuable, I would say –and not just because it’s equally valid at both extremes, top and bottom. The open interest is just one of the sentiment gauges we have. Its advantage is that it’s objective. But remember too that speculation, which is what the IMM open interest tracks, is not just a barometer of price fluctuation; it is a cause of price fluctuation. Commercial or investment

demand may drive price action in the middle stages of a price movement; and this kind of demand is not necessarily price-led. But as trends gather momentum, speculation becomes the dominant driving force behind price and causes the extreme. A price chart can tell us that a price has had an extended move, and that’s all it can tell us; whereas the open interest can indicate to us whether the move is over-extended. It can tell us whether a currency is overbought*, or oversold*.

In the terrible UK bear market of 1974, Burmah Oil was forced to dispose ofits giant stake in BP, since it had borrowed hundreds of millions of pounds on the security of its BP share-holding, and the slide in the price of BP was literally threatening Burmah with bankruptcy .The day after Burmah sold its holding early in 1985, the whole stock market turned on a dime; and within a few weeks the price of BP had doubled again. This wasn’t chance. The threat of Burmah’s forced sale was itself responsible for the last burst of pessimism and bearish speculation in that long bear market. Hence news of the sale turned the tide.