Until now, we have studied various crucial aspects of options. We started right from the basic elements of options such as defining what an option is, the two types of options, moneyness of an option, strike price and underlying price, components of an option price, etc. We then proceeded to discuss about the seven factors that impact the option price, namely: the type of option, underlying price, strike price, volatility, time to expiration,risk-free interest rate, and dividend. Finally, we discussed in detail about each of the five option Greeks, namely: Delta, Gamma, Theta, Vega, and Rho. Now, in this chapter, we shall study about how to read an option chain using two vital tools: Volume and Open Interest. We will use the option chain available on the website of the National Stock Exchange (www.nseindia.com) as our reference. But before discussing about the option chain, let us first understand the basics of volume and open interest.
When trading an option, it is important to ensure that there is enough liquidity among the option contracts that one wants to trade. Trading an asset that is not liquid is risky because of various factors such as choppy price movements, high transaction costs, difficulty in entering and existing trades at the desired price and time, etc. There are a few ways to check for liquidity and one of them is to look at the volume and open interest statistics of an option contract. But what exactly is volume and open interest. Well, volume and open interest are two different concepts, yet are very closely related to each other. Let us now see what these two variables represent and why it is so crucial to understand them as well as to monitor them when entering an option trade and after having entered an option trade. For our discussion henceforth in this chapter, keep in mind that when we talk about volume and open interest, we are talking about them for option contracts only.
Volume refers to the total number of contracts that are created over the course of the day. For instance, a volume of 100 represents 100 contracts have been traded on a particular option during the day. Keep in mind that in the options segment, for every buyer, there is a seller. So, at any point in time, the number of buyers and the number of sellers will be equal. In the case of the above example, a volume of 100 means that there were 100 buyers and 100 sellers and that combined, they accounted for a total volume of 100 contracts.
By itself, volume doesn’t tell anything, especially when trying to confirm the price action. Take the case of the example above. A volume of 100 for this option would say nothing. The trader will instead have to compare this figure either with the past volume data or with the historical average or for that matter even with other option contracts. This would give the trader an idea of whether the volume on a particular option contract at a particular point in time is strong or weak. For instance, continuing with the above example, if other nearby strikes of the same underlying with the same expiry and option type have volumes of 500 or if the option volumes of other underlying are close to 1,000, then it can be said that the volume of 100 for this particular option is relatively low. Hence, an important thing to keep in mind is that volume should never be looked at in isolation.
Once it has been visually determined that an option contract has decent volumes and hence is tradeable, a trader can then use volumes to validate trading signals. Generally, the higher the volume, the greater is the trading interest in the option contract and vice versa. In technical parlance, it is often said that volume goes with the trend. For instance, an up move in option price that is accompanied by an increase in volume is considered as a bullish signal, because it indicates at an increase in buying interest. On the other hand, an up move in option price that is not accompanied by an increase in volume must be treated with caution, because it indicates that there is no buying pressure, which could soon cause the rally to run out of steam. Below mentioned are some general guidelines related to volume and price of an option.
|Up||Up||Bullish||Indicates at strength in the up move, and that the up move is likely to continue|
|Up||Down||Cautiously bullish||Indicates at weak buying pressure, due to which the rally could soon fizzle out|
|Down||Up||Bearish||Indicates at strength in the down move, and that the down move is likely to continue|
|Down||Down||Cautiously bearish||Indicates at weak selling pressure, due to which the decline could soon fizzle out|
Open interest refers to total number of option contracts that have been created but have not yet been closed out. In other words, it refers to the total number of open option positions till date. For instance, an open interest of 500 means that there are 500 contracts that have been created over the life of the option contract but have yet to be closed out. However, unlike volume, which is applicable to both cash and derivatives segment, open interest is applicable to only derivative segment. Just like volume, open interest also tells a lot about the prevailing liquidity in the option contract. High open interest indicates at ample liquidity, and vice versa. Again, one should preferably open position only in those option contracts that have good open interest.
Let us now see how to interpret open interest. Before we start, keep in mind that in options segment, for every buyer, there is a seller. If one party to the trade is buying, say, 50 option contracts, then on the opposite side there are sellers who are selling 50 option contract. Hence, the number of buyers will always be equal to the number of sellers. Now coming back to our main discussion, at any point in time, open interest could change or remain the same depending upon the type of transaction. For instance, if both sides to the transaction (i.e. long and short) are new or old, open interest will change. Else, open interest will remain unchanged. Let us highlight this relationship in a tabular format.
As can be seen from the above table, if a buyer and a seller are both establishing a new position, open interest increases by 1 contract. On the other hand, if a buyer and a seller are both closing out their existing positions, open interest reduces by 1 contract. Meanwhile, if one party to the trade is establishing a new position while the counterparty to that trade is closing out an existing position, open interest remains unchanged.Just looking at open interest doesn’t give a clear picture. Instead, one must always compare open interest with price to understand the strength of the move. In the table below, we have highlighted the relationship between price and open interest.
|Up||Up||Bullish||Indicates new long positions are being built and is likely to support the current up trend in price|
|Up||Down||Cautiously bullish||Indicates at short covering and that the rally could fizzle out once the short covering ends|
|Down||Up||Bearish||Indicates new short positions are being built and is likely to support the current down trend in price|
|Down||Down||Cautiously bearish||Indicates at long unwinding and that the decline could halt once the long unwinding ends|
In brief, open interest that confirms the price action is supportive of the move in the price and indicates that the current trend is healthy and is likely to continue. On the other hand, open interest that does not confirm the price action indicates that the trend is on a weaker footing and could soon run out of steam.
Before proceeding with the main part of this chapter, which is understanding how to read and analyse an option chain, let us first understand the elements of the option chain. As said earlier in this chapter, we will be referring to the option chain that is available on the NSE website. Following are the steps to look at the NSE option chain:
At the top center of the page where there is the search box, type Nifty. Once the drop down list of items appears, select Nifty, as shown in the screenshot below. This will open the quote page for Nifty contracts.
- Now select the Option Chain tab, as shown in the image below. This will open the Option Chain page for Nifty. Once the Option Chain page opens, the user can change the expiry or the strike price of the underlying, if he or she wants to. Also notice that the latest underlying price is mentioned on the right.
- Let us change the expiry date from the weekly expiry to the monthly expiry. Now the Nifty option chain having the monthly expiration will appear on the screen. Below mentioned is a part of the screenshot of the option chain.
In a similar way, the user can also look at the option chain for other index options as well as for various stock options that are traded on the NSE. Besides the Nifty, Bank Nifty index is also heavily traded on the option segment. Among stocks too, there are various option contracts that are available for trading. However, before trading stock options, have a very close look on the volume and open interest statistics of stock options, as only a handful of them are liquid.
Now that we know how to search for the Option Chain of an underlying that is traded on the NSE, let us decipher each element of the Option Chain. Again, let us paste a portion of the Option Chain screenshot that we posted above.
As you can see in the above screenshot, the Option Chain is split in two parts around the central portion, which is the strike price: Calls on the left and Puts on the right. As can be seen, there are various strike price at which options are traded for a particular expiration. There are various statistics that are displayed for each of the option type. Let us now start talking about each of them.
The green icon that appearsfor each strike price at the extreme end of each option type displays the intraday chart of the option for the respective strike price. Both the Call and the Put option for the said strike are displayed in the chart, as shown in the image below:
The OI tab displays the Open Interest statistics for each strike price and for each of the option type. As a rule, the higher the OI, the more liquid the option contract is, and vice versa.
The change in OI tab displays the change in Open Interest that took place during the day for each strike price and for each of the option type. A positive value indicates an increase in Open Interest for that day, while a negative value indicates a decrease.
The Volume tab displays the total contracts traded during the day for each strike price and for each of the option type. As a rule, the higher the volume, the more liquid the option contract is, and vice versa.
The IV tab displays the Implied Volatility for each strike price and for each of the option type. This essentially tells how volatile the respective option contract is. As a rule, the higher the IV, the more volatile is the option price for a given change in the underlying price, and vice versa.
The LTP displays the Last Traded Price (i.e. the option premium)of the Call and the Put option for each strike price.
The Net Change represents change in the price of the Call and the Put option for each strike price from the previous session’s closing price. A negative value (displayed in red) means that the price has declined from the previous day, while a positive value (displayed in green) means that the price has advanced from the previous day.
The Bid Quantity tab displays the number of buy orders (i.e. the quantity) that are placed by the buyers at the respective Bid Priceof a particular strike price.
The Bid Price tab displays the price that buyers are willing to pay to buy the option of a particular strike price.
The Ask Price tab displays the price that sellers are willing to accept to sell the option of a particular strike price.
The Ask Quantity tab displays the number of sell orders (i.e. the quantity) that are placed by the sellers at the respective Ask Price of a particular strike price.
If you observe the Option Chain, you will see that around half of the Calls and around half of the Puts are shaded in light brown, while the remaining are non-shaded i.e. in white. You might wonder what this means. Well, if you notice, you will see that the shaded Calls options are at the top half, while the shaded Put options are at the bottom half. These are the options that are ITM. Meanwhile, the options that are not shaded are OTM options. For instance, look at the below screenshot.
For this option chain, the underlying price of Nifty at the time of writing was 12098. So, at the time of writing, Call options that have strike price below 12098 are ITM and as such are shaded in light brown, while those that have strike price above 12098 are OTM and as such are non-shaded. Similarly, Put options that have strike price above 12098 are ITM and as such are shaded in light brown, while those that have strike price below 12098 are OTM and as such as non-shaded.
Keep in mind that the colour of the option chain does not remain fixed. Instead, as the underlying price changes, the colour of the option chain can also change when a few options move ITM while a few others move OTM.
Now that we understand each element of an Option Chain, it is time to discuss about the main part of this chapter: How to read, interpret, and analyse an Option Chain. Being able to do this is very crucial when trading options because it lets one understand the structure of the underlying in terms of its option positioning. It enables one to know at what level an underlying could find support or resistance as well as gauge what would happen once a key support or resistance is convincingly broken. The shifting OI and volume structure also informs the user about the prevailing trend of the underlying in terms of whether the trend is strengthening or weakening. Changing IVs inform the user about how option participants foresee future volatility, and so on. So, without any further ado, let us get started about how to read and analyse an Option Chain. Let us first post the screenshot of the Nifty Option Chain for contracts expiring on 27thFebruary 2020.
Observe that most of the volume and open interest activity tend to occur around options that are closer to ATM. The further the options are from being ATM, the lower the volumes and open interest tend to get. Also, options that are very deep ITM or very deep OTM have much lesser volume and open interest compared to options that are closer to ATM. Meanwhile, it is worth mentioning that most of the volume and OI activity tends to take place at strikes that are round numbers. For instance, in the image above, compare volume and OI activity for strikes such as 12100 and 12000 versus those for strikes such as 12050 and 11950. It can be seen that activity at round numbered strikes tends to be significantly higher than activity at odd numbered strikes. When opening an option position, keep a note of all these to ensure that both volume and open interest are good enough (i.e. liquidity is ample) to warrant entering a trade.
Volume and open interest tell a lot about the market sentiment, in terms of the positioning of buyers and more importantly that of sellers.Notice here the usage of the word ‘importantly’. Thereason why I have used this is because option writing (i.e. selling) not only requires more margin, but it is also much riskier. Hence, it is usually done by professional traders and large market participants such as FIIs and funds. On the other hand, option buying is usually done by small market participants, such as retail traders. Hence, when lookingat theOption Chain, think from the writer’s perspective and not from the holder’s perspective. In fact, this is another reason why it is important to track the Option Chain. As most of the option writing is done by professionals and large market participants, changing Option Chain structure can often give vital clues about the impending move in the price of the underlying.
Continuing with our discussion, when looking at an option chain, such as the one shown in the image above, look at where most of the open interest positioning is. In the above case, we can see that for Calls, maximum option writing is at 12500 strikefollowed by 12400 and 12200 strikes.This means that at these strikes, a lot of professionals have written Call options and as such, these levels become quite crucial. Similarly, for Puts, maximum option writingis at 12000 strike followed by 11500 and 11600 strikes. Notice the pattern here? See that huge open interest is usually built at strikes that are OTM (the Nifty price at the time of writing was 12098).
As OTM Calls have strikes that are above the underlying price, the strike price of OTM Calls often acts as resistance for the underlying price. Similarly, as OTM Puts have strikes that are below the underlying price, the strike price of OTM Puts often acts as support for the underlying price. Hence, keep in mind that in an Option Chain, OTM Call strikes act as resistance, while OTM Put strikes act as support. In the case of the above example, 12200, 12400,and 12500 are resistances while 12000, 11600,and 11500 are supports. Meanwhile, as 12500 Call and 12000 Put have maximum OI, these are the strongest resistance and support, respectively, in the option series under observation (marked in red in the image above). What this means is that as of now, market participants expect Nifty to move in a range of 12000 and 12500 for the current series. However, keep in mind that with time, this can change.
Continuing with the example above, we know that the key supports to watch out for are 12000, 11600, and 11500; whereas the key resistances to watch out for are 12200, 12400, and 12500. What will happen when one of these levels is breached. Well, let’s take the case of immediate support and resistance - 12000 and 12200. If the underlying goes below 12000, Put writers (remember, Put writers are bullish) could start unwinding their positions as their profitability would start reducing. This unwinding of bullish positions could cause the underlying price to head lower towards the next support of 11600. If this Put unwinding is also accompanied by Call writing at higher levels, this is an even more bearish signal. On the other hand, if the underlying moves above 12200, Call writers (remember, Call writers are bearish) could start unwinding their positions. This unwinding of bearish positions could cause the underlying price to head higher towards the next resistance of 12400. If this Call unwinding is also accompanied by Put writing at lower levels, this is an even more bullish signal.
Besides using Option Chain to identify areas of support and resistance, it can also be used to find out the implications of shifts in support and resistance,as and when they occur. The direction in which support and resistance are moving tells a lot about the overall direction of the underlying instrument. To do this, one must monitor the changes in OI tab for both Calls and Puts. Keep in mind that the entire Option Chain must be monitored and not just the options that are OTM.
If both Call and Put option writers are reducing their positioning in lower-priced strikes and are increasing their positioning in higher-priced strikes, it means supports and resistances are both shifting higher. This is an indication that the trend of the underlying is strengthening. On the other hand, if both Call and Put option writers are reducing their positioning in higher-priced strikes and are increasing their positioning in lower-priced strikes, it means supports and resistances are both shifting lower. This is an indication that the trend of the underlying is weakening.So, supports and resistances both shifting higher is bullish whereas both shifting lower is bearish. On the flip side, supports shifting higher and resistances shifting lower, or vice versa, indicate indecisiveness about the trend of the underlying.
Finally, traders can also use the Option Chain monitor to interpret what changes in price and changes in OI imply. Earlier in this chapter, we added a table showing the relationship between price and OI. Let us show this table again, albeit briefly.
|Up||Up||New longs are being built|
|Down||Up||New shorts are being created|
Let us now try to understand this using the Option Chain monitor of Bank Nifty:
In the above Option Chain, notice that a few of the change in OI and change in price regions have been marked. But before proceeding to explain this, let us now present a table that shows the implications of creating fresh long and short positions as well as closing out existing long and short positions:
|Fresh Longs||Bullish view||Bearish view|
|Fresh Shorts||Bearish view||Bullish view|
|Long Liquidation||Closing of bullish positions||Closing of bearish positions|
|Short Covering||Closing of bearish positions||Closing of bullish positions|
Now, with the above table in mind, notice the boxes that are marked in red in the Option Chain. Here, the open interest has mostly increased and this increase in open interest has been accompanied by a decrease in Call premiums. This is a sign that fresh short positions in Call options are being built. Why are they being built? Well, possibly due to expectations that the underlying price will not move beyond these strike prices at which the positions are being created, thereby enabling the seller to keep the premium.Within this, notice that the maximum change in OIisoccurring in strikes 32000 followed by 32500 and 31500. These are key levels to keep an eye on given that a lot of activity has occurred at these strikes.
Now notice the boxes in purple. Here, the open interest has mostly decreased and so have the Call premiums. This is a sign that traders who had built long positions could be liquidating their longs, either to book profits or to cover losses.Now notice the boxes in black. Here, the open interest has mostly decreased while the Put premiums have increased. This is a sign that those who had built short positions could be covering their shorts, possibly to book profits or cover losses. Finally, notice the boxes in orange. At these strikes, the open interest has mostly increased and so have the Put premiums. This is a sign that fresh long positions are being built in Put options, which has bearish implications.
So, from a very short-term perspective (say, a day or two), a higher number of OTM Call writing and OTM Put addition indicates at a bearish setup. Short unwinding of NTM Put strikes also indicates that bullish positions are being closed out. So, as we can see, activity taking place in the Option Chain can often provide clues as to what might happen in the underlying instrument in the very short-term. Once the Indian markets open, one can wait for some time, say 15 minutes to half an hour, to allow the markets to stabilize and digest overnight developments. How the Option structure of the underlying develops during this period can often provide clues as to what lies ahead in the session ahead.
We have seen how Option Chain can be used to get a holistic picture of the underlying asset that is being monitored. However, we would like to caution the reader that Option Chain is not a substitute for other forms of analysis, such as Fundamental and Technical analysis. Instead, it must be used to compliment the other forms of analysis, especially when building positions in options. Taking trading decisions just based on observations made fromthe Option Chain data can be quite risky. For short-term trading, one can complement Option Chain analysis and Technical analysis to make informed trading decisions. While Technical analysis will help the trader identify the trend and time the market, Option Chain analysis will inform the trader where the maximum activity is taking place and how the overall structure of the underlying is shaping up.
Another important thing to keep in mind is that Option Chain analysis should be done only on instruments that are liquid. Performing Option Chain analysis on instruments that are illiquid will often give incorrect information and will be prone for errors. In case of the National Stock Exchange, instruments that are extremely liquid on the options front are Nifty, Bank Nifty, and the top 10-12 stocks of the futures segment that are also a part of the Nifty 50 index.Examples of liquid stock options include Reliance Industries, TCS, HDFC twins, SBI, ICICI bank, Infosys, Maruti, Hero Motors, Tata Steel Hindustan Unilever, and Larsen & Toubro etc. Having said that, before trading stock options, we would suggest the reader to look at the individual Option Chain monitor to find out whether or not theseinstruments are liquid at any given point in time.
So far, we have talked about Option Chain analysis pertaining to Nifty and Bank Nifty. However, Option Chain analysis can also be applied to stocks, especially the top 10-15 stocks that are a constituent of the Nifty index. Let us take the example of Reliance Industries Ltd, which is India’s largest company by market capitalization.
In the above Option Chain of Reliance Industries, notice that in case of Calls, maximum writing is at 1500 followed by 1600; whereas in case of Put, maximum writing is at 1440 followed by 1400. So, these are key levels that are worth watching. Break below 1440 would open door for further fall towards the 1400; whereas break above 1500 would open door for a rally towards the next hurdle of 1600.
It can also be seen that for all the OTM Put strikes with the exception of 1440 and 1460 as well as for all of the ITM Put strikes, the decline in Put premium has been accompanied by a fall in OI. This indicates at long liquidation and closing of bearish positions. On the Call side, the rise in premiums of ITM Calls accompanied by a corresponding fall in OI indicates at short unwinding by Call writers. Furthermore, there has not been a consistent trend of Call writing at OTM strikes. All these indicate at bullishness in the very short-term. Keep in mind the usage of the word ‘very short-term’ above. I use this word because any noteworthy gap up or gap down on the following session can change the Option Chain landscape.
Let us now take the example of Bajaj Finance, which is a stock that is a part of the Nifty index and also has decent activity in the Options segment.
Notice in the above Option Chain the region marked in red. On the Call side, we can see that an increase in Option price has been accompanied by a decrease in OI, which is indicative of short unwinding by traders who had written Calls previously. On the Put side, notice that the decrease in Option price has been accompanied by an increase in OI, meaning fresh shorts are being written. Fresh Put writing between strikes 4500 and 4800 suggests that this region could act as strong support zone going forward. Having said that, short unwinding of Calls between 4500 and 4800 suggests that the underlying could break above the upper end of this range.
Let us now recap some of the important concepts that we talked about in this chapter.
There are a few ways to check for liquidity and one of them is to look at the volume and open interest statistics of an option contract.
Volume refers to the total number of contracts that are created over the course of the day.
Generally, the higher the volume, the greater is the trading interest in the option contract and vice versa.
Open interest refers to total number of option contracts that have been created but have not yet been closed out. In other words, it refers to the total number of open option positions till date.
High open interest indicates at ample liquidity, and vice versa. Again, one should preferably open position only in those option contracts that have high open interest.
One must always compare open interest with price to understand the strength of the move.
Open interest that confirms the price action is supportive of the move in the price and indicates that the current trend is healthy and is likely to continue.
On the other hand, open interest that does not confirm the price action indicates that the trend is on a weaker footing and could soon run out of steam.
Most of the volume and open interest activity tend to occur around options that are closer to ATM. The further the options are from being ATM, the lower the volumes and open interest tend to get.
It is worth mentioning that most of the volume and OI activity tends to take place at strikes that are round numbers.
Volume and open interest tell a lot about the market sentiment, in terms of the positioning of buyers and more importantly that of sellers.
When looking at the Option Chain, think from the writer’s perspective and not from the holder’s perspective. As most of the option writing is done by professionals and large market participants, changing Option Chain structure can often give vital clues about the impending move in the price of the underlying.
In an Option Chain, OTM Call strikes act as resistance, while OTM Put strikes act as support.
Option Chain can be used to identify areas of support and resistance as well as to find out the implications of shifts in support and resistance, as and when they occur.
Supports and resistances both shifting higher is bullish whereas both shifting lower is bearish.
For short-term trading, one can complement Option Chain analysis and Technical analysis to make informed trading decisions.
In this Chapter, we will study about some of the important concepts that we have not studied so far in the Options Module. It is equally important to understand each of these concepts, as they are extremely useful, especially when trading options.