How can traders make the best of Option Chain?

Blog | TRADING 101

In the last 10 years, option volumes in India have picked up in a big way. Not only are options useful in hedging risk but also in trading with a much lower risk. First, let us spend a couple of minutes on the concept of options. An option is a right (without an obligation) to buy or sell a stock or an index. A right to buy is a ‘Call’ option while a right to sell is a ‘Put’ option. The buyer of the call/put option has risk limited to the premium paid but profits can be unlimited. The situation reverses in the case of an option seller.

Trading options is a little more detailed compared to trading stocks or futures and one of the best ways to understand options trading is through option chain. Let us first look at the concept of option chains first:

How does the Nifty option chain look like and what does it mean?

Data Source: NSE

The above is an option chain wherein for all the strikes, the call and put data are juxtaposed to each other. In one glance, you get all the information about each strike. Typically, an option chain trading strategy is formulated by seeing accumulations in Open Interest (OI) and volumes in various option strikes. Let us look at how to interpret the above option chain on the Nifty and create actionable trading calls on the same. Here is how to interpret Nifty option chain:

  • It is a quick picture of In the Money (ITM) and Out of-the Money (OTM) options. The strikes shaded in yellow are the ITM options (calls and puts); the un-shaded strikes are OTM options.
  • Traders can quickly evaluate liquidity and depth of each specific strike. That is because the chain captures real-time bid price, ask price, bid quantity, and ask quantity; apart from the execution price.
  • The option chain also acts as an advance warning system, ahead of sharp moves (either ways) or breakouts. For example, sudden spurt or reduction in OI of a particular strike is advance indicative of some imminent trading opportunities.
  • While we have only covered the immediate option strikes around the spot price for want of space, you can see all the strikes on your trading screen. That screen can help you spot opportunities in deep Out of-the Money (OTM) calls and puts. Normally, sudden spurt in action in deep OTM calls and puts is indicative of a break out in that direction. You can play that trend by either using options or future or even cash equities.

How options traders can interpret stock option chains?

Data Source: NSE

The above is an option chain analysis of Reliance Industries. Stock option chain can be useful as a stock level/sector level indicator; if not for the market as a whole. Here is how:

  • Traders can get the best single shot view of all the strikes in the market on a particular stock. Which strikes are liquid and which strikes carry basis-risk can be judged with this sheet.
  • Normally, long-only institutions hedge their positions by purchasing put options. The option strike analysis can highlight at what price traders and investors are getting sceptical about a stock. You can tweak trades accordingly.
  • Option chain can be used to define a trading range for the stock. Normally, stocks take support where institutional put selling is concentrated and stocks peak out where the institutional call selling is concentrated. This is useful input, especially if you are looking to either buy or even sell volatile strategies like straddles and strangles.
  • As a trader you may be getting a lot of tips in the market about a particular stock. However, you are not sure what to believe and what not to believe. Here, option chains can help you; at least where the stock is in F&O. Is there a sudden spurt in volumes and OI in deep OTM calls or deep OTM puts? It is a signal for you to probe deeper. Even otherwise, this can work as a last level screener for your stock buy/sell decisions.

Upstox’s option chain tool is precisely designed so that traders can make the best of this mountain of useful data and convert them into actionable trades. Here is a video of how it works. You can also read a how-to blog about the same.