Option Chain Analysis in Trading
First lets cover the basics of Option chain….
- What is open interest?
- How to study option chain table
- The element of the option chain table
- How to interpret option open interest
- Use of open interest
- Market Structure Principles
Price moves within a structural framework of the supply and demand zone. A breakout of the structural framework supply and demand zone will lead to price movement in the next area of the framework of the supply and demand zone
OPTION CHAIN COMPONENT
WHAT are ITM (IN THE MONEY) OPTIONS?
- A call option is said to be in ITM if the strike price is less than the current spot price of the security.
- A put option is said to be ITM if the strike price is more than the current spot price of the security.
WHAT are ATM (AT THE MONEY) OPTIONS?
- A call option is said to be in ATM if the strike price is equal to the current spot price of the security.
- A put option is said to be ATM if the strike price is equal to the current spot price of the security.
WHAT are OTM (OUT OF THE MONEY) OPTIONS?
- A call option is said to be in OTM if the strike price is more than the current spot price of the security.
- A put option is said to be OTM if the strike price is less to the current spot price of the security.
Open interest
WHAT Changes in Open Interest?
- SAY TWO participants in trade are initiating a new position, the open interest will increase. If both participants are liquidating/squaring off an old position, the open interest will decline.
- SAY ONE participant is initiating a new trade while the other is liquidating/squaring off an old trade, open interest will remain unchanged.
Note : Never think that since PRICE is rising, more LONGS are being created than SHORTS. LONGS will always be equal to SHORTS just that LONGS are dominating SHORTS in the transaction, that is why PRICE is rising
Now what drives share market that is number of shares bought is ALWAYS EQUAL to the number of shares sold. So why PRICE rises or falls?
That price is determined by either buying or selling pressure. If the Buyers of a contract outnumber the Sellers, the PRICE will rise; if the Sellers outnumber the Buyers, the PRICE will fall. However, in a trade, BUYERS will always be equal to SELLERS. As a result, open interest is increasing, which means that new contracts are being added. However, because the PRICE is rising alongside it, it means that LONGS are DOMINATING the transactions. As a result, the market/share is STRONGLY BULLISH. The inverse represents a bearish trend…
WRITING/Selling(Sellers) are more accurate and in power. We know why?
- It takes conviction to sell as there is Unlimited risk and more money required
- Sellers are usually someone with Big money like Big Institutions
- Buyers are usually retail traders as it is convenient with the less required capital
- Institutions are usually right
- Large option open interest means massive bet against that strike price
Now CALL OI increase means Sellers are betting market wont go up – Bearishness
Now PUT OI increase means Sellers are betting market wont go down – Bullishness
Use of open interest data
- To identify support and resistance
- To find out when support resistance will break
- Direction of trend
Identifying Support and Resistance based on option chain open interest
The OI built up means Sellers are betting that it wont cross that point.
Like high OI built on Put can act like Support and high OI built on Call can act as Resistance.
How to identify support and resistance level or zone?
- STEP 1 find the highest OI column on both sides (call and put side)
- STEP 2 note the corresponding change in OI
- SUPPORT (PE) biggest open interest number + positive change in open interest
- RESISTANCE(CE) biggest open interest number + positive change in open interest
Using volume with OI
How to know where is the resistance in an all-time high price?
- By analyzing the option chain data
PARTICULAR STRIKE PRICE in Option Chain Analysis
Now we will study what is a particular strike price showing us?
| CALLS | PUTS |
- A positive change in OI indicates that call writers are selling because they believe the stock will not rise above the relevant level.
A decrease in OI indicates that call writers are squaring up because they believe the stock will rise above the respective level. | - A positive change in OI indicates that put writers are selling because they believe the stock will not fall below the relevant level.
A decrease in OI indicates that put writers are squaring up because they believe the stock will fall below the respective level. |
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Now analysing this data we can analyse per STRIKE PRICE any of the following:
- LONG BUILDUP – If open interest increase and price also increase means long buildup.
- LONG LIQUIDATION – long unwinding means price are decling and open interest are also decline.
- SHORT BUILDUP – If open interest increase and price are going down means short buildup.
- SHORT COVERING – short covering means price are going up but open interest are decling.
Note: Open interest any position are open in derivative contract ,means one buyer buy a position simultaneously one seller sell a position both position are open and they count 1 open interest.
LONG BUILDUP in Option Chain Analysis
If PRICE is rising and open interest is rising, it means the market is STRONGLY BULLISH. LONG BUILDUP
- If PRICE and OI both are rising, it means that the new contract that is being added is dominated by bulls, that’s why PRICE is rising with every new contract addition.
Short-covering in Option Chain Analysis
If PRICE is rising but open interest is falling, it means the market is WEAKLY BULLISH. Short covering
- If the PRICE is rising but open interest is falling, it indicates that the price rise is due to SHORT COVERING rather than bullishness. See why OI is decreasing. It is declining as positions are squared off and the number of open contracts in the market decreases. However, because PRICE is rising alongside it, SHORTS are SQUARING OFF and dominating LONGS in the transaction. See how SHORTS would square off? They will settle their differences by BUYING. That is why the PRICE is increasing. As a result, the PRICE is not rising because LONGS are dominating. It is on the rise because SHORTS dominate the squaring off process. As a result, it cannot be called BULLISH. It is ONLY SLIGHTLY BULLISH. It has the potential to be a TRAP for new LONGS.
- Rally Price up with high volume is bullish, extrapolating from the general rule. However, if open interest falls during the same trading session, the variable takes on a bearish reading. During such a trading session, the market’s internal condition would be that of short covering. A rally of short-covering is a very weak technical situation. The technician can state that the drop in open interest is more bearish than the increase in volume. In fact, if the volume is so high that it is considered to be of blowoff proportion, the volume reading would be bearish as well, indicating at least a temporary reversal of the price uptrend.
SHORT BUILDUP in Option Chain Analysis
If PRICE is falling, open interest is rising, the market is STRONGLY BEARISH.
- If the price is falling and open interest is rising, it means that SHORTS are dominating the LONGS. And since open interest is rising, it means that new contracts are being added. But, since the price is falling, it means the new contracts which are being added are dominated by SHORTS, not LONGS. Hence, it is STRONGLY BEARISH.
LONG LIQUIDATION in Option Chain Analysis
If PRICE is falling and open interest is falling, the market is WEAKLY BEARISH.
- If the PRICE is falling and the open interest is falling, it means that the price is falling due to LONG COVERING, also known as LONG UNWINDING. See why open interest is decreasing. It is declining as positions are squared off and the number of open contracts in the market decreases. However, because PRICE is falling along with it, LONGS are SQUARING OFF and dominating SHORTS in the transaction. LONGS, how would you square off? They will square the circle by SELLING. That is why PRICE is decreasing. So, because SHORTS are dominating and creating new positions, PRICE is not falling. It is falling as a result of LONGS dominating the squaring off process. As a result, it cannot be called BEARISH. It is BEARISHLY BEARISH. It can be a TRAP for new SHORTS.
Also MARKET DIRECTION BASED ON OPTION OI
- In which direction both support and resistance are shifting. if both shiftings higher is indicate bullishly
- By change in OI in particular Strike Price
Now think in terms of sellers to analyse the market to combine both calls and put
- Call writer adding(increasing) and put writer exiting(decreasing)=bearish
- Put buyers adding(increasing) and call buyers exiting(decreasing) = bearish
- Call writer decreasing(exiting)and put writer adding(increasing)=bullish.
- Call buyers increasing(adding) and put buyers decreasing (exiting )=bullish
OPTION CHAIN TABLE FOR ABOVE CHART
REVERSAL STUDY
- If near CE OTM strike price has the highest open interest and positive change in open interest, then the price will not break that level. means call writers feel that price will not move above that level
- PUT WRITER exiting means open interest decreasing in ATM and ITM PE, put sellers or writers feel that price will move below that level.
BREAKOUT STUDY
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- If near CE OTM strike price has changed in negative open interest, then the price will break that level. call writer is exiting means they are feeling price will move up
- Addition in ATM AND ITM PE means put writers are bullish
Put Call Ratio (PCR) – Total Puts number is shown at bottom on option chain and same for Calls.
HIGH PCR =BULLISH
- More puts than calls
- Big sellers are selling puts, more than calls
- This means they are saying the market won’t go down much
PCR RANGE INTERPRETATION
- BELOW 0.5 MEANS STRONGLE BEARISH
- BETWEEN 0.5-0.8 MEANS BEARISH
- BETWEEN 0.8-1.2 MEANS NEUTRAL OR SIDEWAYS MARKET
- BETWEEN 1.2-1.6 MEANS BULLISH
- ABOVE 1.6 MEANS STRONGLY BULLISH
We have now covered in this article the Option Chain Analysis in Trading.
