How to use Option chains while trading?
Having a basic understanding of calls and puts is vital for an F&O (Futures & Options) trader. But that’s certainly not enough to gain any significant mileage in trading. It’s time to acquire a functional knowledge of options. As a first step, let’s learn what an option chain is and how one can use it effectively for trading.
What is option chain?
Option chain or option matrix offers complete information of all available calls and puts on an underlying stock or an index for a specified expiry in a tabular format. This includes data on premium, volumes along with Open Interest (OI) and changes thereof for all available strike price levels.
Option chain is divided largely into two parts with data on calls displayed on the left-hand-side and that on puts on the right.
This is how an option chain/option matrix looks
For illustration purposes only
The key components of option chain are:
Open Interest (OI): Simply put, Open Interest or OI in options reflects the number of outstanding contracts on each side—call and put. Calls OI shows the number of call-side open contracts and Put OI denotes those on the Put-side. Once you know what the OI is, a change in OI becomes self-explanatory.
Volume: Newbies often confuse OIs with volumes. We have already seen the former; the latter suggests how many trades happened at each strike price.
Implied Volatility (IV): Implied volatility denotes the anticipated price volatility of an underlying asset until option expiry. A change in IV can have an immediate bearing on an option premium. In general, rising volatility will make options expensive and vice-a-versa. More the time to expiry, greater would be the impact of IV and vice-a-versa.
These are the most important components to analyse in an option chain/option matrix.
Moreover, bids and asks tell you the price and quantity of options bought and sold at each strike price.
What does an option chain indicate?
- Option chain indicates which options are In-The-Money (ITM), At-The-Money (ATM) and Out-of-The-Money (OTM). This enables traders to choose their desired strike price. In general, ATM and Near-The-Money options will be more sensitive to IV as compared to the other two.
- A quick glance at an option chain can help a trader know the most popular strike price levels and liquidity therein.
- Tracking activities in the most popular strike price levels can offer you crucial information on a potential trading range.
- A careful assessment of an index option chain might offer crucial information about potential market movements and support and resistance levels. A stock-specific option chain can offer similar info on a particular stock.
How to use option chain for trading?
Option chain forms the basis of any advanced options trading strategy. A few factors are available readymade such as OI and IV while a few others can be obtained easily. For instance, Put-Call-Ratio (PCR).
Put-Call-Ratio (PCR) = Total Put-side OI / Total Call-side OI
PCR denotes who’s more dominant—bulls or bears. Extreme skewness on either sides hints at extremely high speculation and thus complacency.
For example, Calls OI of 22.30 lakh Vs Put OI of 17.60 lakh will give you a PCR of 0.79, suggesting that call writers are more active. But can you, thus, conclude that markets are expecting a downward move? Well, this certainly is an indicator of such a potential move but not conclusive enough.
What if PCR drops to say 0.40 or jumps to 2.5? It means participants are too bullish or too bearish—skewed opinions.
An improving OI on the put options side (vis-à-vis that on call options side) generates positive signals. In simple words, it highlights an increased put writing activity—a bullish sign. Some may call it a contra-way of thinking but please don’t forget, option writers hold the key in options trades and their market perception often becomes the deciding factor in the actual movement of a stock or an index.
Here’s a caution—don’t use PCR in isolation. You should simultaneously evaluate other indicators such as implied volatility and time to expiry amongst others.
Option chain captures all….
Normally, OTMs start losing their value quickly as the time to expiry nears. Deep OTMs often become worthless too quickly. That said, a sudden and massive change in OI in deep OTM options may indicate a possibility of a sharp rise/fall in the underlying asset. You should carefully track such changes.
A seasoned trader analyses different components of an option chain—OI, IV and PCR amongst others—to devise various option strategies.
Always remember, option chains are dynamic; meaning you can’t be complacent after taking a trading position. You have to monitor option matrix continuously. OIs can change overnight, mirroring a sudden change in the expectation of market participants.
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