In the near future I want to share some exercises to help you learn how to correctly interpret derivatives data. But before I can do that we need to go over the basics!
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Terminology
Open interest (OI)
Open interest is the total amount of outstanding derivatives contracts. In simple English: all the positions on derivatives markets that traders still haven't closed yet.
Of course you can't know exactly what trade every single market participant is taking, but the way OI moves in relation to price can give you valuable hints on how the majority of the market is trading!
Funding rate (FR)
A mechanism that aims to tether the price a perpetual swap contract, the most actively traded derivatives contract in crypto, closely to the average price of the spot market. It could be considered some sort of interest rate that market participants either have to pay or receive depending on the rate and on how they're positioned.
Funding positive: longs pay shorts.
Funding negative: shorts pay longs.
Funding rate payouts happen on most exchanges every 8 hours.
The predicted funding rate is the exchange constantly trying to calculate based on current price action what the next FR is going to be.
Futures basis
The difference in price between futures contracts with a settlement date and the spot market.
Note: the funding rate is based on the difference between perps and the spot market, while the futures basis is based on the difference between classic futures contracts (with expiry) and the spot market.
Cumulative volume delta (CVD)
The sum of all market buys and market sells.
I've written a detailed article about this which I recommend you check out first if you're not familiar with this indicator.
Liquidation
A liquidation is a forced close of a derivatives position.
The exchange will do this for you when your losses are too great compared to your margin.
If you're long a liquidation executes as a market sell.
If you're short a liquidation executes as a market buy.
Examples
With just open interest alone we can definitely make some assumptions.
Generally speaking:
Price up + OI up = longs
Price up + OI down = shorts closing
Price down + OI up = shorts
Price down + OI down = longs closing
Side note: the act of positions closing is also often referred to as "covering".
However, this is pretty nonchalant inference. It's, of course, better to combine open interest with other indicators for confluence and completeness of your analysis.
Let's take a look.
In this example I added the CVD indicator. We see that price goes up and OI also goes up. We already make the assumption that market participants are opening directional longs. After taking a look at the CVD we get confirmation of our initial hypothesis because it shows that there is a lot of market buying going on. OI up + market buying = longs increasing.
Here price goes down, OI goes down, and the CVD also goes down (market selling).
This is an example of longs covering.
Price down, OI up, we assume shorting.
CVD goes down, that means selling, so it's confirmation that there's indeed a lot of shorting going on.
Price up, OI down (we assume short covering), CVD up (buying).
This is an example of short covering.
Maybe this one is a bit more tricky to understand. I recommend also reading my article about open interest. However I'll briefly give some more information about this.
When a long closes it turns into a sell.
When a short closes it turns into a buy.
That's why in this example when you see OI going down (people closing positions) and CVD going up (buying) it indicates that shorts are closing their positions which turns all of those shorts into buys.
This is also why short squeezes or simply the act of covering shorts tends to lift the market higher.
Let's add another indicator for confluence!
Once again I recommend first reading my articles about open interest, CVD and perpetual swap contracts. I'll give you much needed context to really understand all of these examples.
In this example price goes up, OI goes up (we assume longs), and the funding rate flips from negative to positive. The funding rate going positive means that the perp is starting to trade higher than the spot market. Why would that be? It's very likely that it's because more and more people started buying (longing) on perps. Hence, this is an example of directional longs opening.
Price down, OI up (we assume shorting), and the funding rate keeps dipping into negative territory.
This is an example of shorts opening. We also get confirmation of this later on when the price starts going up and the OI goes down (short covering).
I think that's enough for this post. In another post we'll start doing some real exercises based on the stuff we've seen here and more! Stay tuned.