Option Chain Analysis in Trading

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Option Chain Analysis in Trading

In this article, I am going to discuss the Option Chain Analysis in Trading. Please read our previous article in which we discussed Opening Range Breakout with examples. At the end of this article, you will understand the following pointers in detail, which are related to Option Chain Analysis.

1. What is Option Chain Analysis in Trading?
2. What is open interest?
3. How to study option chain table
4. The element of the option chain table
5. How to interpret option open interest
6. Use of open interest

Market Structure Principles

Price moves within the structural framework of the supply and demand zone. A breakout of this framework will lead to price movement in the next area of the framework.

OPTION CHAIN COMPONENT

WHAT ARE ITM (IN THE MONEY) OPTIONS?

1. A call option is said to be in ITM if its strike price is less than the security’s current spot price.
2. A put option is said to be ITM if the strike price is higher than the security’s current spot price.

What are ATM (AT THE MONEY) OPTIONS?

1. A call option is said to be in ATM if the strike price is equal to the current spot price of the security.
2. A put option is said to be an ATM if the strike price is equal to the current spot price of the security.

WHAT ARE OTM (OUT OF THE MONEY) OPTIONS?

1. A call option is said to be in OTM if its strike price is higher than the security’s current spot price.
2. A put option is said to be OTM if the strike price is less than the current spot price of the security.

Open interest

How Changes in Open Interest Occur

• If both participants in trade are initiating a new position, the open interest will increase. If both participants liquidate an old position, the open interest will decline.
• However, if one participant initiates a new trade while the other liquidates an old trade, open interest will remain unchanged.

Misconception about open interest

Never think that since the PRICE rises, 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

The number of shares bought is ALWAYS EQUAL to the number of shares sold. Then why does the PRICE rise or fall? because of buying pressure or selling pressure. So, if buyers of a contract are dominating the sellers, PRICE will rise, and if sellers are dominating the buyers, PRICE will fall. But BUYERS will always be equal to SELLERS. So, open interest is rising, which means new contracts are being added. But since PRICE is rising with it, it means that LONGS are DOMINATING the transactions. Thus, the market/share is STRONGLY BULLISH. Opposite of the bearish trend

WRITING/Selling(Sellers) is more important here….. 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 a massive bet against that strike price

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

How do we identify support and resistance levels or zones?

• 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

How do we know where the resistance is at an all-time high price?

• By analyzing the option chain data

PARTICULAR STRIKE PRICE in Option Chain Analysis

Now, we will study what a particular strike price shows us.

CALLS	PUTS
+ve change in OI implies that call writers are selling because they feel the stock will not rise above the respective level -ve change in OI implies that call writers are squaring up because they feel the stock will rise above the respective level	+ve change in OI implies that put writers are selling because they feel the stock will not fall below the respective level -ve change in OI implies that put writers are squaring up because they feel the stock will fall below the respective level

“STRIKE PRICE” will show any of the following:

1. LONG BUILDUP
2. LONG LIQUIDATION
3. SHORT BUILDUP
4. SHORT COVERING

LONG BUILDUP in Option Chain Analysis

If the PRICE is rising and open interest is rising, it means the market is STRONGLY BULLISH. LONG BUILDUP

• If PRICE and OI both rise, it means that the new contract being added is dominated by bulls; that’s why PRICE rises with every new contract addition.

Short-covering in Option Chain Analysis

If the 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 means that the rise in price is due to SHORT COVERING and not bullishness. See why OI is falling? It’s falling because positions are being squared off, and the number of open contracts in the market is reducing. But since the PRICE is rising with it, it means that SHORTS are SQUARING OFF and dominating LONGS in the transaction. See, how would SHORTS square off? They will square off by BUYING. That is why PRICE is rising. So, PRICE is not rising because LONGS are dominating. It is rising because SHORTS are dominating the squaring-off process. Thus, it can not be called BULLISH. It is WEAKLY BULLISH. It can be a TRAP for new LONGS.
• Rally Extrapolating from the general rule, the price increase with high volume is bullish. However, if open interest drops during this same trading session, a bearish reading of that variable results. The internal condition of the market during such a trading session would be that of short covering. A short-covering rally is a very weak technical situation. The technician can state that the decline in open interest is more bearish than the high volume is bullish. In fact, if the volume is so high that it can be considered to be of blowoff proportion, the volume reading would also be bearish, signaling at least a temporary reversal of the price uptrend.

SHORT BUILDUP in Option Chain Analysis

If the PRICE is falling, open interest is rising, and the market is STRONGLY BEARISH,

• If the price is falling and open interest is rising, it means that SHORTS are dominating the LONGS. Since open interest is rising, new contracts are being added. But, since the price is falling, the new contracts that are being added are dominated by SHORTS, not LONGS. Hence, it is STRONGLY BEARISH.

LONG LIQUIDATION in Option Chain Analysis

If the PRICE is falling and open interest is falling, the market is WEAKLY BEARISH.

• If the PRICE is falling and open interest is falling, it means that the fall in price is due to LONG COVERING, also called LONG UNWINDING. See why is open interest falling? It’s falling because positions are being squared off, and the number of open contracts in the market is reducing. But since PRICE is falling with it, it means that LONGS are SQUARING OFF & dominating SHORTS in the transaction. how would LONGS square off? They will square off by SELLING. That is why PRICE is falling. So, PRICE is not falling because SHORTS are dominating and creating new positions. It is falling because LONGS are dominating the squaring-off process. Thus, it can not be called BEARISH. It is WEAKLY BEARISH. It can be a TRAP for new SHORTS.

MARKET DIRECTION BASED ON OPTION OI

• In which direction both support and resistance are shifting. If both shiftings are higher, it is indicated bullishly.

HOW TO KNOW?

• BY CHANGE IN OPEN INTEREST IN PARTICULAR STRIKE PRICE

Let’s study call open interest (CE OI)

Let’s discuss putting open interest (PE OI)

Let’s 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

WHAT HAPPEN NEXT

Let’s see the option chain data for this chart

BREAKOUT/REVERSAL

Let’s study bullish breakout and Bull-to-bear reversal

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 to feel that the price will not move above that level
• PUT WRITER exiting means open interest decreasing in ATM and ITM PE; THEY FEEL THA PRICE WILL MOVE BELOW THAT LEVEL

BREAKOUT STUDY

• If the near CE OTM strike price changes in negative open interest, the price will break that level. call writer is exiting, which means they are feeling the price will move up
• The addition of ATM AND ITM PE means put writers are bullish

Put Call Ratio (PCR)

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

Please watch the following video if you want to learn and understand the Option Chain Analysis in Trading concept in a better way.

In the next article, I am going to discuss the Relative Strength Index Trading Strategy. In this article, I try to explain Option Chain Analysis in Trading. I hope you enjoy this Option Chain Analysis in the Trading article. Please join my Telegram Channel and YouTube Channel as well as my Facebook Group to learn more and clear your doubts.