Mastering Option Chain Analysis: Top 5 Points to Consider

Introduction

An option chain is simply the list of all the available option contracts for a particular underlying stock or index with a specific expiry. It is often shown in a grid format on brokerage platforms. An option chain offers data for call and put options across multiple strike prices and expiration dates, with important information including bid/ask price, volume, open interest, and all the Greeks.

The option chain is used by traders to look for potential trades. A trader can easily assess the option chain data and choose the right contracts that are in best alignment with his strategies and risk tolerance. For example, a trader may look through the option chain to find an acceptable strike and expiry for a bull call spread or a cash-secured put.

Structure of an Option Chain

The option chain structure consists of some elements without which one cannot trade options. Option chain is generally presented in a grid or tabular format. Strike Prices are placed in the centre of the grid. Details of Call Options are shown on the left side of the Strikes and details of Put Options on the right-hand side.

Each row on the grid/table represents a different strike price, and each column provides some key data like bid price, ask price, volume, open interest, implied volatility (IV) etc.

Structure of Option Chain in NSE

Let’s explore the key elements using the structure of option chain of NSE (National Stock Exchange, India) as shown below. Let’s consider the NSE market index “Nifty” as a reference for explanation.

Please note that some broker or service provider shows more information on their option chain. For example, Sensibull ( https://web.sensibull.com/ ) provides all the Greeks and color-coded open interest data.

Top 5 Key Elements of an Option Chain

Although there are quite a few elements shown in an option chain, following five are most important to consider while analysing the date and taking a trade.

• Strike Price: The predetermined contract price at which the option can be exercised.
• Bid/Ask Prices: The prices at which traders can buy or sell their options.
• Open Interest (OI): The number of outstanding contracts open at a given time.
• Volume: The number of contracts traded at a given time.
• Implied Volatility (IV): The market’s expectation of future volatility.

Strike Price:

The strike price is the price at which an option holder has the right to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset.

Strike prices allow traders to choose levels that match their market view. Strike price along with delta provides an indication of the probability of being in-the-money of that strike. The higher the delta of a strike, higher the probability.

In-the-Money ITM) strikes carry higher delta whereas Out-of-the-Money (OTM) strikes will have a lower delta and hence a lower probability of being in the money at expiry. For example, a 0.3 delta strike has a 30% probability of being in the money at expiry, and so on.

Bid/Ask Prices:

The bid/ask price is provided by ‘market maker’. A market maker is a professional trader or financial institution who provides liquidity in the market by continuously quoting both bid and ask prices for options contracts.

The bid price is the price at which the market maker is willing to buy an option from a trader and it is generally lower than the ‘ask’ price. This means that when a trader wants to sell a contract (strike) he will have to pay the ‘bid’ price from the option chain.

The ask price is the price at which the market maker is willing to sell an option. This price is generally higher than the bid price. When a trader wants to buy a contract (strike) he will have to pay the ‘ask’ price from the option chain.

The key here is the Bid-Ask Spread. It is the difference between the bid and ask price. A narrow spread indicates high liquidity. This is very important while selecting a strike for taking a trade. A lower spread means a trader can enter and exit trades at a favorable price.

From a trader’s perspective, the spread affects the total cost of entering and exiting a trade position. Wider spreads higher costs.

Open Interest (OI):

Open Interest (OI) refers to the total number of outstanding options contracts (either calls or puts) that have not yet been settled or closed. It essentially indicates the total number of active contracts in the market for a particular strike price and expiration date.

Open Interest is an important element in understanding market sentiment, gauging the strength of price levels, and identifying potential support or resistance levels.

Open Interest is often seen from the option seller’s perspective. When a particular strike price has very high open interest in call option, it often indicates a resistance level. Traders can expect that the price will stay below that strike level, as sellers at that strike have more confidence that it won’t rise above that point.

Similarly, a strike price with high OI in put option generally acts as a support level, where traders can expect that the price to stay above that strike level.

Interpreting OI Changes to Confirm Price Trend

Changes in open interest along with price movements can confirm the strength of a trend.

• Price Increase + Rising OI: It usually confirms a strong uptrend.
• Price Increase + Falling OI: It is considered as a short covering rally.
• Price Decrease + Rising OI: It usually confirms a strong downtrend.
• Price Decrease + Falling OI: It indicates long liquidation or long unwinding.

Volume:

Volume shows the number of contracts traded on a particular day. This means that every day the volume figures are reinitialized in the option chain at the beginning of the trading session.        

Higher volume or above average volume indicates a strong interest and liquidity on a particular strike, that helps a trader entering or exiting from a trade easily. In other words, high liquidity or narrow bid-ask spread. High volume also supports the direction of price movement and indicates stronger momentum.

Implied Volatility (IV):

Implied Volatility (IV) is the market’s expectation of future volatility. IV is the most critical factor in trading options. IV is derived from the option’s current market price and represents the level of price fluctuations that the market anticipates for the asset till the expiry date.

Implied Volatility directly affects an option’s premium (price). When IV is high, options become more expensive because there’s a higher chance of large price movements. Conversely, when IV is low, options are cheaper as the market expects smaller price fluctuations.

When a trader believes that a stock or index is likely to experience higher volatility in the future, buying options in a low-IV environment will be profitable. This is because options are cheaper to buy. During the period of high IV, selling options can be a profitable strategy, as high IV will inflate the option prices. Hence, option premiums are more expensive. IV subsequently drops, the option premium will decrease in value and there by making profit. IV is mean reverting in nature. This means higher IV will return to it’s mean (average) value. So an experienced trader generally considers net short strategies to benefit from high IV situation.

Interpreting the Option Chain for Trading Decisions

By now it is clear that taking an option trade is not simple as it has multiple aspects that influence the success of a trade and make it profitable. So, understanding the above five factors, combining and correctly applying them can benefit a trader. Option chain analysis is the key to success in option trading.

A Broad Guideline before considering a Trade

• Market direction and sentiment – appropriate strike selection
• Volatility in the market – check the IV of the strike
• Cost of trade – Liquidity of the strike, bid/ask spread
• Trader’s participation – check the volume of the strike
• Trader’s engagement and conviction – Open Interest (OI) situation
• Change in market sentiment – track the ‘change-in-OI’, price and volume

Conclusion and Key Takeaways

This structured approach of analysing the option chain may be beneficial to all traders. A trader can take a data-driven informed trading decision with confidence. A trader must emphasize on understanding and combining all these factors to improve his trading decisions.

Market is dynamic and hence a regular option chain analysis is required to align with trading strategies and adapt to the changes in the market conditions.