Understanding The Option Chain

Option chain is a very popular tool for data analysis among derivatives traders. It is available on the NSE website and there are other software too offering this feature, writes Prashant Shah, Co-founder & CEO Definedge Securities 
 

Option chain is basically a data table. When you select the symbol and expiry of any instrument, you get the data of all the strike prices of that instrument. The option chain captures information such as the premium, open interest, volume and implied volatility of each strike price of that instrument. It is presented in a very structured way, and it can help assess the strength of the trend and the important support or resistance level of the instrument. Let’s understand how to read it. 

Structure

There are two parts in the option chain table. The left part captures the data of call options and on the right is the data of put options. Further, there are two parts of each of these. The strike price near the current price of the instrument is known as at-the-money (ATM) strike price. The strike prices above the ATM strike price are the upper area strike prices in call and put options while the strike prices below the ATM strike price indicate lower area of call and put sections. The upper part of the call option data shows in-the-money (ITM) strike price call options and the lower part shows out-of-the-money (OTM) price call options. The upper part of the put option data shows OTM strike price put options and the lower part shows the ITM strike price put options. The image alongside will offer better clarity and idea about the data presented in the options chain. 

Featured below is the option chain table from the Opstra software: 

LTP is the last traded price. OI is the open interest. We can also see the change in open interest as well. There are also columns capturing information about the volume and implied volatility. Open interest, volume and price are the most important conditions in the option chain. When price, volume and open interest increase, it is considered a bullish sign. When price falls with increase in volume and open interest, it is considered a bearish sign. In this article, we will discuss the price and open interest columns for an analytical perspective. 

First, look at the open interest numbers and the change. High open interest would indicate increased activity in that call or put option strike price. Option chain is always analysed from a seller’s perspective. The selling option needs more margins and hence it is assumed that the smart money writes options and retail traders buy option. The market is expected to move in the direction of smart money positions. Though I don’t completely agree that more money means smart money, it’s a discussion best left for some other day. Let us understand what information we get from the option chain table. 

Support-Resistance

We write or sell call option when the view is neutral to bearish. We write or sell put options when the view or market outlook is neutral to bullish. So, when the open interest increases in any call option strike price, that is a sign that more calls of that strike price are written. Hence, that level is expected to act as resistance. When open interest increases in put option strike price it implies that more put options of that strike price are written and hence the level is expected to act as a support level. When you notice a sudden spike in open interest in any strike price, then that level assumes a lot of importance. Thus, one useful feature of option chain is to get an idea of the important price levels that can act as support or resistance for the instrument. 

If you know technical analysis, you can corroborate the data from the options chain with the charts’ analysis. If the charts also confirm and there is evidence of demand or supply at that level, then those levels become extremely important. When the market approaches the support level, you can create bullish position by buying future or call option or selling put option. 

Similarly, when the price is at or near the resistance level, you can create a bearish position by selling future or buying put option or selling call option. Typically, there will be a high open interest in OTM calls and OTM puts that gives you a range of market on the higher side as well as on the lower side. Observing the shift in the strike prices and change in open interest will give you an idea about the market trend. 

Breakout

Support and resistance or deriving levels based on option chain analysis works like a charm in sideways or narrow range markets. But strong trends need a different treatment. When there is a significant call option open interest addition at any strike price and if the price crosses it, a significant upside move may be expected. Because there were many call writers at that strike, they are likely to run for cover, which could fuel a rally. Similarly, when the price drops below a level where significant puts were written, it indicates the possibility of a further slide. 

Trend Strength

There is another observation that you can focus on. We have open interest data of call and put options of the same strike price. For any strike price, when open interest of put is more than the open interest of call option, it indicates a bullish sign. In other words, puts written are more than the calls written at that strike price. Similarly, if the open interest of call option is more than the open interest of put option, it is a bearish sign. When open interest of put option increases but the open interest of call option does not change much for that strike price, it shows that more puts are being written but new calls are not being written. Hence, it is a bullish sign. 

Bears are writing options and bulls are just watching. However, if open interest of the calls starts reducing for that price, it becomes very bullish because more puts are being written and calls writers are exiting. In the same way, if the open interest of call option increases but the open interest of put option does not change much, it is a bearish sign. However, if the open interest of put options starts reducing at that strike price, it becomes very bearish. As mentioned earlier, OTM options generally would have higher open interest because they are comparatively safe to write or sell. They are far from the current price and writers can take advantage of the theta decay by writing them. ATM options have highest intrinsic value. Generally, we will see high open interest at ATM or near the strike price when the market trend is range-bound. 

When put option open interest increases at multiple strike prices in ATM and OTM options and call option open interest of ATM and OTM strike prices starts decreasing, it is a sign of a strong market trend. As the open interest data can change quickly, it is important to keep track of it while using the option chain table. Using technical analysis along with option chain analysis is a nice combination to try. High implied volatility indicates that the option premium is expensive. In the upcoming write-ups, we will discuss how to read and interpret implied volatility in the option chain.