Long or short?

As someone who mostly analyses the state of the market by using derivatives data I often share charts with open interest, and the most asked question I always get is: “Ser, are these longs or shorts?”.

Funny enough that’s a very silly, yet at the same time very smart question to ask. It’s silly because it clearly shows a lack of understanding of the data, but it’s also smart because the whole point of analysing derivatives (and spot) data is to figure out how market participants are positioned and how they fair in relation to how price is moving.

So, allow “ser” to once and for all answer the question.
This might be a long article because I’ll explain everything by using a specific example and I’ll post many charts.

Quick disclaimer: I’m a, left on the bell curve, cartoon tiger, randomly pressing buttons. Don’t get mad at me if you somehow get rekt using the information I share. Think about who you took advise from.
Anyway, lets’ dive in.

Big words

First and foremost, let’s make sure you understand all the terminology.

Open interest is the total amount of outstanding derivatives contracts. In plain and simple English: positions that traders currently have open.
There’s a common misconception about whether these are mostly longs or shorts. The long/short ratio is always 1 to 1, meaning that there are always an equal amount of longs and shorts, because derivatives markets in crypto are peer to peer. However, most of the time the market does have a clear directional bias, which means one side of the trade will dominate. This is possible because your counterparty isn’t always a directional gamble… I mean professional speculator like you and I. Sometimes you buy or sell into market maker liquidity. Market makers aren’t taking bets on which direction price is going to go, they simply provide liquidity and they would love it actually if price went perfectly sideways forever. Your counterparty might also be hedging, taking a delta neutral trade and of course there are also always contrarians (real directional traders who simply have a different idea about the market than you do).

The only well known exception in crypto to this 1:1 long/short ratio rule is margin trading on the Bitfinex spot orderbooks, that’s why you sometimes see people post long or short charts that seem unbalanced. But forget about that for now. The most actively traded derivatives contracts in crypto, “the perpetual swaps”, are all p2p contracts with a 1:1 ratio.

The point I’m trying to make is that even though the long/short ratio is technically always equal, the market does often have a very clear bias and some market participants are easier to get squeezed out of their positions than others because of the speculative nature of their trades.
In the mid to late 2020 bull market for example, most market participants wanted to go long. Nevertheless there were still people on the other side of the trade because of, mostly, market makers and hedgers or people collecting positive funding and a few actual bears who were either in disbelief or maybe they’re trading on a lower timeframe.
But of course, even though there are market makers and hedgers, if the market’s really bullish, price will have to go up rapidly to find sufficient liquidity for eager buyers. These market makers aren’t here to give you the best deal possible, they also want to make money and they use models to figure out where price should be and sometimes they’ll pull liquidity and place it further away from the current price. That’s why in 2020 you probably heard some people speak of a “sell side liquidity crisis”, there were way more natural buyers than sellers and then of course numba go up.

By the way, because the most common directional trade in a bull market is the long trade, you’ll mostly see long liquidations and not short liquidations. The real directional traders are net longs that pile on and trade with higher risk. So often times when price has a bit of a correction during a bull market it quickly turns into a liquidation cascade. I don’t need to tell you how degenerate traders can get when FOMO is high.

It’s not always easy though to determine whether the market is mostly compromised of directional longs or shorts. If it was, we would all be billionaires, wouldn’t we. But there are tools that give us hints and can make us better understand how people are positioned.

First a few more terms I’ll briefly explain although I think most of you are already familiar with these.

The funding rate is a mechanism used to keep perpetual swap contracts in line with the underlying spot market. Perpetual swap contracts, or “perps” in short, are like classic futures except they are continuous contracts without an expiration date. To make sure that the price of this instrument doesn’t completely deviate from the spot price, traders have to pay funding. If the perp trades above spot funding will be positive and longs will have to pay shorts just to keep their positions open. It’s an incentive for longs to close their positions and for new shorts to open, so that the perp price can snap back to to reality, I mean the spot price. Vice versa when the perp trades below spot funding will become zero or even negative and shorts will have to pay longs. These funding pay-outs happen every 8 hours on most exchanges, FTX is the most popular exception, pay-outs happen every hour there.
There’s also predicted funding. Most exchanges try to constantly and continuously calculate what the next funding rate will be.

Liquidations I hope you’re not familiar with but you probably are. This is basically the exchange that forces you out of your trade with a market order when you’re losing too much money on your leveraged trade.

Cumulative volume delta (CVD) is market buys and market sells added up. When there are more market buys than sells the CVD will go up, when there are more market sells than buys the CVD will go down.

Up or down, Byz?

On the seventh of February 2022 I posted a tweet with the following chart, saying I thought BTC looked bullish.

The result was a 10% pump.

This isn’t a humble brag, I get things wrong plenty of times, but this is the example I’m going to use to explain everything.

Remember the main goal of using derivatives data is to figure out how market participants are positioned and how they fair in relation to how price is moving. Basically what I’m trying to figure out is which side of the trade is offside because those people usually get blown out. With “offside” I mean: aggressive, badly positioned and at risk of getting squeezed.

So why did I feel like this was a bullish setup?
First let’s take a look at the structure of the chart.

After printing a bottom at 33k, bitcoin had been in a short term uptrend and on the fourth of February there was a decent pump. But after that bitcoin started ranging and felt more like a stablecoin than anything else. That is until that one strange pump happened that immediately got fully retraced.
Let’s take a closer look at what was happening during that range.

You can see on the chart above that every single time BTC pumped even a little bit, open interest went down instead of going up which you would normally expect. This is a first sign that the market is actually heavily short biased. That suspicion is further confirmed by looking at liquidations. On every pump, however small, there were lots of short liquidations and during the entirety of the range there were very few long liqs. Despite the few shakeouts, open interest was still decently high though. And now we have a pretty strong suspicion that the biased, directional speculators are shorts.

Another hint that showed that shorts were more offside than longs is the fact that funding was more often than not at baseline or even negative which means shorts have to pay just to keep their positions open.
Especially after that one strange pump out of nowhere that fully retraced, funding went seriously negative while open interest climbed. This was to me a strong signal that speculators thought that the retrace was a sign of more downside to come and shorts started piling on.
The direction of funding compared to price movement is also important. You can see that price and open interest went up while funding went down. This happened twice. It’s significant because it suggests that the move is getting faded and any and all shorts that are getting opened are pretty much immediately underwater.

All of the tools we just used give us hints that it’s shorts who are “offside”.

Use brain

Using a bit of common sense is also crucial when doing this type of analysis.
I know, I’m asking the impossible, but try to think logically about where most people opened a position and how they’re feeling about their position and their pnl right now.

I come back to this chart. Remember even before this range open interest indicated that the market was already short biased. You can see here that the average price at which most positions opened was about $41500.
Longs that opened before the pump or during the range are chilling, especially because funding was often negative. So they’re not underwater for the most part and they’re actually getting paid to keep their positions open. Even after that strange pump that retraced we could see based on open interest and liquidations that there wasn’t a huge influx of degen longs, and on top of that price immediately landed back onto support. So longs are sitting pretty comfy.

Meanwhile shorts are sweating a little bit. The ones that opened before or during the initial pump and are still holding on to their positions are most likely nervous. Keep in mind there are real human beans with feelings behind these positions. Sounds silly but it’s very relevant. Those emotions dictate how they manage their trades.
The shorts that opened during the range also aren’t exactly comfortable either because they’re the ones paying funding and price refused to go down. Then that pump happened which fully retraced, but even that wasn’t salvation because price pretty much immediately start crawling back up again.
It was only a matter of time before shorts puked, which means fuel for a pump.

Conclusions

Let’s analyse a bit further.

After the strange mini pump price went up again and more short liquidations came in. This is proof that the conclusion was correct, shorts were offside and they got squeezed.

One more interesting aspect of this example I want discuss as an exercise is the fact that open interest started going down towards the final part of the pump. That divergence in open interest and price means that shorts were covering. Short covering simply means the closing of short positions. As you can see the CVD kept going up while open interest went down. CVD going up means market buying. But a short is a sell, and when a short has to close it turns into a buy because you have to buy back what you sold on margin. So CVD going up with price while open interest goes down tells you in this instance that shorts were covering.
This can also be a sign that the pump is close to coming to an end. In my opinion price going up on decreasing open interest isn’t bad at all (although some traders might disagree), but if there are no new longs entering the market that would push up open interest, then you could interpret that as natural demand disappearing. So as soon as shorts are done covering there might not be any fuel left to keep the pump going, unless the spot market goes wild and lifts everything up, but that was pretty unlikely in this time of geopolitical uncertainty.

Final thought I want to share is that you should always look at this data in context of what’s happening in the market.
After a 50% correction bitcoin had broken a multi month downtrend. Some relief was to be expected. Therefore it’s no surprise that btc started a bit of an uptrend after printing the 33k bottom.
Looking for a long opportunity in an uptrend is always going to give you better odds than looking for a short.
Secondly, after that pump that fully retraced price fell back down onto support. Going long at support will of course give you better odds than going short at support. Also looking at orderbooks might give you some more information on whether there’s actually demand or not.
All I’m trying to say is: don’t tunnel vision, use common sense and look at the context of the market.

That’s it!
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That’s all for now, I think the article is long enough.
Let me know if you like this type of content because I actually have no clue if anyone is interested in this stuff.

Bye bye!