In response to overwhelming demand from our audience, we’re back with an in-depth exploration of a trader’s favorite tool: the option chain. If you’re new to trading, or if the concept of option chains still leaves you puzzled, fret not! This blog is tailored for beginners, aiming to provide crystal-clear insights into the world of option chains.
Option chains are essentially financial contracts that derive their value from an underlying asset, often stocks. If you’re wondering about the abbreviations CE and PE, it’s simple: CE stands for Call Option, and PE represents Put Option. But what’s with the “E”? It refers to European-style options, the prevalent type in India.
In the distant past, American options (Call American and Put American) were the norm. These options allowed traders to exercise their contracts at any time before the contract’s expiration date. American options are analogous to Americans’ go-getter attitude—they want things now.
In contrast, European options (Call European and Put European) are more structured. Traders can only exercise these contracts at the expiration date. European options align with the prudent, future-focused mindset often associated with Europeans.
When traders approach the market, most dive into price action and their preferred setups. However, an astute trader knows that the option chain holds valuable insights. Before setting eyes on anything else, they assess the option chain. Why? because it provides a window into market sentiment, potential support and resistance levels, and possible price movement trajectories.
Let’s take a moment to understand the distinction between European and American options. Just like the cultural traits they embody, European options adhere to a fixed schedule—much like adhering to plans punctually. These contracts are executed solely on their predetermined expiration date, whether it’s weekly for indices like Nifty or monthly for individual stocks. This predictability empowers traders with the foresight of when contracts will be settled.
Now, why is this distinction important? It boils down to advantage. European contracts favor sellers, as they’re bound to the specified expiration date, granting them a degree of control. On the flip side, buyers of European contracts are bound by this schedule and can’t exercise their options before the expiration date. This presents an intriguing power dynamic where sellers maintain a degree of advantage due to their ability to predict and control their actions.
With this foundational knowledge, we dive into the heart of the matter: understanding option chains. When we buy a call option, we’re essentially expressing a bullish view on the underlying asset. Conversely, purchasing a put option reflects a bearish sentiment, predicting a decline in the asset’s value. On the contrary, if we sell a call option, we anticipate the asset’s value to remain stagnant or decrease, while selling a put option signifies an expectation of a rising asset value.
Let’s journey into the practical aspect by exploring the NSE website’s option chain for Nifty. It’s advised for newcomers to avoid the more volatile Bank Nifty and focus on Nifty to start. As you navigate the NSE website, you’ll find the option chain section. You’ll need to select an expiry date—keep in mind that weekly options expire on Thursdays. The difference in days between successive expiries is typically seven days, allowing you to plan your trades more effectively.
Within the option chain, you’ll encounter strike prices for both call and put options. These represent the levels at which a particular option contract can be exercised. The prices for these options fluctuate based on market dynamics, supply, and demand. Understanding these strike prices and observing their behavior over time provides traders with insights into potential support and resistance levels for the underlying asset.
Imagine the option chain as a shelf of dairy products, and we’re looking at two items: butter and cream. In this analogy, “butter” is our go-to term for options that are In-the-Money (ITM), while “cream” is our term for options that are Out-of-the-Money (OTM). To spice things up, we’ll visualize “add the money” as a splash of golden yellow.
Add-the-Money (ATM): This is where things are happening right now. Just like when you add cream to your coffee, it blends right in. In our case, “add the money” refers to options with a strike price near the current market price. If the Nifty is around 16,350, any options around this level are our “add-the-money” options.
In-the-Money (ITM): Imagine butter, that rich, valuable goodness. It’s solid, it’s substantial, and it’s IN demand. Similarly, options are In-the-Money when the strike price is already favorable. For call options, this means the strike price is below the current market price (butter is valuable), and for put options, the strike price is above the market price (cream is not so appealing).
Out-of-the-Money (OTM): Cream, the lighter layer that floats above milk. It’s not as dense or substantial. In the options world, when the strike price is away from the current market price, we’re dealing with Out-of-the-Money options. These are options that haven’t become valuable yet, much like cream not being as desirable as butter.
Now that you’ve got the dairy analogy down, let’s return to the option chain itself. When you glance at the call options, you’ll notice a pattern. The nearer the option’s strike price is to the current market price, the more valuable it is—just like butter’s rich appeal. These “add-the-money” or ATM options command higher prices (LTP), reflective of their immediate value.
Conversely, as you venture away from the current market price, the options become less valuable (like cream being less dense). This is the case for both call and put options. When you see yellow on the option chain, remember that the option is In-the-Money and holds more value.
Imagine your option chain as a map with two critical destinations: determining the market’s likely range for the day and understanding the anticipated market direction.
Visualize the option chain as a tool to forecast the market’s possible movement range. This is pivotal for strategies like short straddle, butterfly, iron butterfly, and condor. The magic lies in pinpointing the “add-the-money” option, which corresponds to the current market price. By examining nearby strike prices, you can gauge the potential price fluctuations and set informed entry and exit points.
Now, let’s unravel the direction the market might take. This is where the distinction between In-the-Money (ITM) and Out-of-the-Money (OTM) options comes into play. Consider ITM options as valuable “butter” and OTM options as “cream” with potential. Yellow-colored options signify that the intrinsic value—the value based on the current market price—is present, indicating the direction the market is leaning towards.
When diving into the option chain, pay attention to two key components: intrinsic value and time value.
Intrinsic Value: This value corresponds to how much an option is “in the money.” For example, if Nifty is at 16,350 and an option has a strike price of 16,200, the intrinsic value is 150 points. In the option chain, yellow-colored entries indicate the presence of intrinsic value, offering insight into the market’s expected movement.
Time Value: This aspect is particularly significant. It’s the portion of an option’s premium beyond its intrinsic value. In other words, it accounts for the speculative element of the option. As you move away from the “add-the-money” point, you’ll notice white-colored entries lacking intrinsic value but holding time value. This indicates that traders are speculating on potential future movements.
Imagine you’ve entered the options market with a carefully chosen call or put option. You’re confident, but the market doesn’t budge, ending the day right where it began. What happens? This is where Theta decay comes into play.
Theta decay, often referred to as time decay, is the silent erosion of an option’s value as time progresses. If the market remains stagnant, the premium you paid for the option gradually diminishes. This decay primarily affects options with strike prices that are Out-of-the-Money (OTM), those that haven’t yet acquired intrinsic value. As time advances, the “time value” component of the premium diminishes, potentially leading the option’s price towards zero if the market doesn’t move favorably. In essence, time is working against the value of your option.
Let’s simplify the calculation of intrinsic value. It’s simply the difference between the current market price (Spot price) and the option’s strike price. If Nifty is trading at 16,350 and the option’s strike price is 16,000, the intrinsic value is 350 points. When you see an option’s price, the difference between this intrinsic value and the total option price is the “time value.”
In options trading, understanding open interest and its implications is crucial. When analyzing the option chain for Nifty, such as at strike price 16,350, 16,400, and 16,300, you notice significant differences in open interest. Sellers with large positions indicate significant investments, while buyers, often retail traders, possess relatively smaller stakes.
This disparity in invested amounts reveals that market movement is predominantly driven by entities with substantial capital. Retail traders with limited funds cannot significantly impact the market, whereas institutional players with crores of rupees possess the ability to dictate market direction.
An important takeaway is that sellers, possessing large holdings, are less likely to incur losses. This insight informs your perspective on market ranges and potential price movements. Understanding this dynamic enables you to recognize that the market’s true movers are entities with considerable capital, not individual traders with limited resources.
Considering Nifty’s composition of top 50 companies, including industry giants like Alliance and HDFC, institutional players wield substantial influence due to their significant holdings. Any actions they take, whether buying or selling, can significantly impact market direction.
Focusing on open interest and strike prices, you can grasp how institutional players influence price movement. The call and put options data at various strike prices presents a clear picture of resistance and support levels.
For instance, examining the call options at 16,350 and 16,500 reveals significant open interest. Sellers at 16,500 aim to prevent the market from rising beyond this point to safeguard their positions. Similarly, at 16,800, another resistance level arises due to substantial open interest. This logical reasoning demonstrates that entities with significant capital drive market action, as they have a vested interest in maintaining their holdings’ value.
On the put side, observing open interest at 16,000 showcases the market’s support level. Sellers with substantial stakes will work to prevent the market from dipping below this point, thereby protecting their investments. This analysis establishes a range-bound scenario where the market is expected to remain between 16,000 and 16,500.
However, determining market direction involves additional efforts. To find out whether the market will rise or fall, further investigation is needed. This might entail considering factors beyond the option chain data and performing more in-depth analysis.
For a clearer picture, let’s focus on the Put Call Ratio (PCR). By summing change in open interest on both the put and call sides, traders can calculate PCR—a vital metric offering insights into market sentiment. Consider an example where the change in open interest for puts amounts to 1 crore shares, and for calls, it’s 50 lakhs. This yields a PCR of 2, indicating bullish sentiment. Similarly, if PCR exceeds 1.5, a bullish market is likely; a value below 1 suggests reduced bullishness. Extremes like PCR over 4 signify an extremely bullish outlook, whereas PCR below 0.2 implies significant bearishness.
Furthermore, interpreting this data assists traders in formulating strategies. Notably, if PCR hovers around 1, a sideways market can be expected. Sellers, with substantial holdings, aim to avoid losses by influencing market movement. Buyers, on the other hand, may face potential losses if their positions are larger.
PCR, when used as a tool, offers insights into market sentiment and potential direction. Trading based on PCR enhances your probability of success. While trading strategies aren’t foolproof, PCR can guide your decisions with about a 70% accuracy rate. Out of 10 trades, an expectation of 7 profitable outcomes and 3 losses can be anticipated.
Nonetheless, a challenge arises in the form of ever-changing data. Analyzing PCR every 5 minutes could be cumbersome, leading to a need for a more streamlined approach. Here, the Autotrender software comes into play. It simplifies the analysis by presenting PCR data for Nifty and Bank Nifty at 5-minute and 15-minute intervals.
Crucially, the timing of trading is pivotal. A golden rule emerges: never trade before 11 AM. Early trading, when the market is still forming data, can lead to misguided decisions. Professional traders often enter the market after amateur activity has subsided, typically post 11 AM. This approach aligns with the notion that professionals close the market, while amateurs tend to open it.
Autotrender software complements this strategy by offering PCR analysis in real-time, highlighting the PCR’s fluctuating trends as the day progresses. Recognizing that early morning PCR values may be misleading, Autotrender recommends using PCR data after 10:30 AM when a more reliable picture of the market sentiment emerges.
An important aspect to grasp is that while PCR offers valuable insights, it’s not a guaranteed success formula. Instead, it increases the probability of profitable trades to around 70%. Once PCR surpasses 1.5, indicating a bullish sentiment, it’s prudent to wait until it reaches around 2 or above to mitigate false signals. However, PCR alone isn’t sufficient; it needs to be coupled with other indicators for a comprehensive analysis.
Crucially, VWAP acts as a guiding light for entry points. The logic is simple yet powerful: refrain from entering trades until the price approaches the VWAP. This approach reduces potential stop losses and minimizes risks. By waiting for the price to come closer to the VWAP line, traders gain a clearer picture of market direction and minimize the possibility of entering a trade too early, only to face a reversal.
The Autotrender software streamlines this process by providing real-time PCR analysis, saving traders the hassle of manual calculations. However, it’s essential to note that timing matters significantly. Never trade before 11 AM, as the market needs time to form reliable data, and the presence of amateurs can lead to misleading trends.
VWAP’s significance becomes evident through its ability to enhance entry accuracy. Waiting for the price to align with VWAP improves trade timing, reducing potential losses and increasing the likelihood of profitable outcomes. A disciplined approach of combining PCR insights with VWAP entry points ensures traders make informed decisions based on data, increasing their trading success rate.
Implied Volatility (IV) is a critical concept to understand in the realm of option trading. It serves as a gauge of the market’s anticipation of potential price swings in the future. To explain it simply, think of a sudden announcement that alters the market’s stability, like a surprise lockdown. Such unforeseen events create uncertainty, leading to increased volatility. IV measures this fluctuation and impacts option prices.
Consider this scenario: if the government suddenly announces a lockdown, uncertainty about market stability spikes, leading to higher volatility. This elevated IV translates to an increase in option prices. Consequently, in an environment where prices are rising, buying options may seem unwise due to their increased cost. Instead, it might be more strategic to sell options.
Furthermore, IV can be influenced by the prevailing market trend. For instance, if the market trend is predominantly bearish, but short-term government interventions, such as a reduction in excise duty, temporarily stimulate positive sentiment, the overall market direction remains bearish. This phenomenon underscores the “sell on the rise” strategy. While a temporary stimulus might cause prices to ascend, the overarching bearish trend prompts cautiousness and encourages taking profit on rallies.
It’s worth noting that high IV can lead to expensive option prices, making selling options a smarter choice. On the other hand, in times of low IV, option prices tend to be more reasonable, making buying options more attractive. Ultimately, understanding IV empowers traders to make informed decisions based on market expectations and price dynamics.
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