After my previous article on trading the right contract, I got many questions about the merits of using open interest to find the most liquid contract versus using volume. Many of the questions related to volume and why we don't just use volume to determine where the liquidity is. There is of course a very good reason for this.

Let's start with a brief background of the problem. When you trade futures or CFDs based on futures, you have a limited lifespan for each instrument. The December Nasdaq contract will cease trading by the end of that month and then you need to move your position to the next contract. For most financial futures this is fairly straight forward and just a matter of always being in the next expiring contract, rolling just before expiry. For commodities however, as well as for some rates markets, things are quite a bit more complex.

No firm rules
In any given commodity, there will be one contract that currently has almost all liquidity. It might be the next expiring contract, but it doesn't have to be. There are no firm rules and you just have to observe the market to make sure you always stay with the liquidity. If you trade a different contract, you risk poor executions and mispricing due to the low participation in that contract.

I previously wrote stick with the contract that has the highest open interest. This is a measure of how many open contracts there are at any given time in a futures contract. An open interest of 10,000 means that there are ten thousand open long contracts at the moment. If someone nets his position with an offsetting trade, the open interest goes down. If he opens new contracts, the open interest rises.

Volume on the other hand is just a measure of the number of contracts that changed hand during the measured period. One might think that volume is more important in finding the best liquidity, but there is an important reason why this logic does not hold up.

Let's look at the last time Comex gold rolled as an example. Look at the two charts below. The first one shows the August 2013 gold and the second, the December contract. What you see is that while the open interest, in green, dropped fast for August, the volume for the same contract did not.

August 2013 gold contract, with volume and open interest