Option Chain Analysis in Trading
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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 pointersin detail, which are related
to Option Chain Analysis.
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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
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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
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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
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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.
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CALLS PUTS
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+ve change in OI implies that call +ve change in OI implies that put
writers are selling because they feel writers are selling because they feel
the stock will not rise above the the stock will not fall below the
respective level respective level
-ve change in OI implies that call -ve change in OI implies that put
writers are squaring up because they writers are squaring up because
feel the stock will rise above the they feel the stock will fall below the
respective level 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
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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.
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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)
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Let’s discuss putting open interest (PE OI)
7/12
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
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OPTION CHAIN TABLE FOR ABOVE CHART
WHAT HAPPEN NEXT
Let’s see the option chain data for this chart
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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
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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
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Please watch the following video if you want to learn and understand the Option Chain
Analysis in Trading concept in a better way.
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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
Dot Net Tutorials
About the Author: Pranaya Rout
Pranaya Rout has published more than 3,000 articles in his 11-year
career. Pranaya Rout has very good experience with Microsoft
Technologies, Including C#, VB, ASP.NET MVC, ASP.NET Web API, EF, EF Core,
ADO.NET, LINQ, SQL Server, MYSQL, Oracle, ASP.NET Core, Cloud Computing,
Microservices, Design Patterns and still learning new technologies.
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