I came across this article and became curious. Can the futures market's open interest really predict market action?
CXO-Advisory investigate the claim of this paper and conclude that evidence indicates that changes in open interest in futures markets are strong predictors of returns for associated asset classes, even after controlling for a number of conventional predictors.
They state that investors may be able to exploit these predictive powers via tactical asset class allocation but nevertheless warn that the study does not explicitly translate this evidence into a realistic trading strategy.
Maybe a better question title is "Can futures market open interest predict commodity, treasury, and equity returns"?
I saw this paper in an earlier form and it still baffles me. Superficially, it makes sense that price*quantity holds more information than just price when quantity can change quickly (i.e., outstanding futures contracts changes more quickly that outstanding equity shares). Open interest is the dollar value of outstanding futures contracts, so there are two sides to these contracts, and of course each side thinks that they're getting the better deal. So it's not really clear that this should be a bull or bear indicator. If the price component dominates, then this could just be a CPI precursor, which would drive the returns in treasuries and equities.
Also, the open interest term is a rolling average, which makes it highly autocorrelated. On this they regress treasury returns, which are also autocorrelated, so there could be some spurious regression in there. But Hong and Yogo are top of the field, so there's most likely something I'm overlooking and I'm interested in your thoughts.
After I saw this paper, I tried the same thing in equities. I got data from the OneChicago single stock futures market and tried to use open interest and open interest growth to predict equity returns. I couldn't find anything more powerful than short term reversal. The OneChicago single stock futures market has only been around since the mid-2000s and still has relatively thin trading. Maybe in a few more years there will be enough volume to get better tests?
So, I don't think open interest predicts returns in a profitable way. It can predict returns, but not any better than short-term reversal or other documented mechanisms.
My main concern when I read this paper was that they appear to not be lagging the CFTC data appropriately. The open interest data is reported with almost a week delay. They are using 1yr smoothing of 1mth changes, so that will mitigate some of the look ahead bias, but I think the paper is untradeable.
I just skimmed the paper, but it looks like Tables 6 through 10 hold the "predictors". Notice the R^2 values. I assume that their R^2=3% is my R^2=0.03. If that's true, I would guess that trading frictions would dominate any of their predictions.