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"Analysis of Open Interest"
1. OI refers to Open Interest.
2. Chng in OI indicates the Change in Open Interest.
3. IV stands for Implied Volatility.
4. Volume represents the trading volume,
Additionally, there is the strike price.
What information is required for us to make informed decisions?
1. Identify the Strike Price and Open Interest (OI) corresponding to the maximum Open Interest in Put Options (PE) - MAX_OI_PE.
2. Determine the Strike Price and Open Interest (OI) associated with the maximum Open Interest in Call Options (CE) - MAX_OI_CE.
3. Ascertain the Strike Price and Change in Open Interest (CHG) where the maximum change in Open Interest occurs in Put Options (PE) - MAX_CHGOI_PE.
4. Establish the Strike Price and Change in Open Interest (CHG) where the maximum change in Open Interest is found in Call Options (CE) - MAX_CHGOI_CE.
Intraday trading strategies would rely on fluctuations in Open Interest (OI), while positional or swing trading approaches would focus on OI levels.
Rule 1: A bullish market is indicated when the maximum change in open interest (CHG in OI) for put options (PE) exceeds the maximum change in open interest for call options (CE).
What makes MAX (CHG in OI) PE a bullish indicator?
1. The existence of a market relies on the presence of both Bears and Bulls. Each day, the market operates within a defined range. It is reasonable to assume that Bulls will endeavor to safeguard the lower end of this range, while Bears will aim to defend the upper end, preventing the market from exceeding these boundaries.
Bulls typically hold long positions, and to protect these investments, they often engage in the options market by selling puts as a hedge. This strategy allows them to profit from options if the market moves against their long positions.
Generally, market makers profit from both the equities and options markets. When establishing significant volume around a specific strike price, they effectively communicate to the Bears, "This is our territory, and we will not allow you to breach it."
2. A market's functionality is contingent upon the presence of both Bears and Bulls. Each trading day, the market operates within a predetermined range.
It is logical to conclude that Bulls will strive to defend the lower boundary of this range, while Bears will work to maintain the upper boundary, ensuring the market does not surpass these limits.
Bulls typically hold long positions, and to mitigate risk, they often sell puts in the options market as a form of hedging. This approach enables them to generate profits from options if the market moves contrary to their long positions.
In most cases, market makers derive profits from both equities and options. When they create substantial volume around a particular strike price, they essentially signal to the Bears, "This is our domain, and we will not permit you to encroach."
Below this threshold, BULLs typically manage a Lower Strike, while BEARS generally oversee an Upper Strike. On any given day, this range serves as the Intraday Range.
Rule 2: When the maximum change in open interest for put options (PE) is less than the maximum change in open interest for call options (CE), it indicates a bearish market. The reasoning is similar to that of a bullish market.
Rule 3: For positional or swing trading, utilize the open interest (OI) rather than the CHN in OI, adhering to the same guidelines established in Rule 1 and Rule 2.
Rule 4: How does the volume in the options chain data influence our decision-making process?
Indeed, analyze the Volume data to determine if the market is exhibiting characteristics of a STRONG BULL or a STRONG BEAR.
Let us understand by example
At a price level of 6100, we observe the maximum change in open interest for call options, which stands at 6 lakh positions. Conversely, at 6000, the maximum change in open interest for put options is recorded at 11 lakh positions.
Currently, 11L is greater than 6L, and the put equivalent (PE) exceeds the call equivalent (CE), indicating a bullish trend. Next, we will examine the volumes at the 6100 CE and 6000 PE levels.
Volume at 6100CE is 5.5 lakh, while at 6000PE it is 17 lakh.
Please evaluate the change in open interest (CHG in OI) alongside the volume for the 6100CE. The current volume stands at 5.5L, which is below the 6L threshold, indicating that it does not signify a strong bullish trend. If the volume had exceeded the change in open interest, it would have indicated a stronger bullish sentiment.
The same reasoning applies to the STRONG BEAR as well.
An additional observation: Consider initiating a Naked Long position in Call or Put options only when the volume at the strike price exceeds the change in open interest.
If the Volume does not reflect the aforementioned indicators, it is likely that the market is experiencing a range-bound condition.
Rule 5: Is it always appropriate to apply this reasoning to MAX(OI) and MAX(CHG in OI)?
It is advisable to avoid engaging in the market during the final week of expiry, as market makers typically close their positions at this time. Instead, consider utilizing implied volatility strategies if you choose to participate in the market during this period.
Rule 6: In the context of CHG in OI, what implications arise from encountering negative values? What insights can be derived from this situation?
When negative values appear in "CE," it indicates that market makers (bears) are closing their call positions (short positions). A significant reduction in CE positions serves as a bullish indicator, suggesting that a breakout may occur if there is a sudden increase in squaring volume.
This situation often arises unexpectedly within a timeframe of 10 to 20 minutes, prompting us to exit our short positions immediately and consider going long.
The situation is reversed when we encounter significant negative values in "PE."
In the event that we observe negative values in both the put and call options, we should proceed to sell the open interest pair without hesitation.
Minor negative values suggest the typical practice of profit realization.
Rule 7: For intraday trading, I determine bullish or bearish signals based on the "Change in Open Interest." How do I proceed with purchasing options? What criteria should I use to decide whether to buy or sell the options?
This is a significant and challenging question.
Unless the market is experiencing a strong bullish or bearish trend, a prudent strategy would be to sell the pair to minimize risk. For instance, if the range is identified as 5800PE and 6000CE, one should consider selling both the 5800PE and the 6000CE.
Rule 7B: I prefer not to engage in Pair Trading. Instead, I am inclined to take on greater risk by executing naked Calls and Puts. What criteria should I use to determine whether to BUY or SELL?
Utilize the Implied Volatility by selecting the top five most actively traded strikes. From these, compute the average volatility for both put and call options. Additionally, determine the historical volatility of the underlying futures.
For instance, if we consider NIFTY, the historical volatility (HVOLT) is 21.18%.
The average PE VOLT stands at 18.78%, while the average CE VOLT is recorded at 19.4%.
The analysis indicates that both PE VOLT and CE VOLT are below the HVOLT threshold, suggesting a low volatile market condition.
Rule 8: Honor the Strike Price at which the MAX Pain is located.
The strike price at which the maximum pain occurs acts as a focal point for market movements. Particularly as the expiration date approaches, the market tends to gravitate towards this maximum pain level.
Therefore, during the final week before expiration, it is advisable to refrain from purchasing any out-of-the-money (OTM) call options near the maximum pain, as these options are likely to expire worthless. For instance, in the July 13 expiration, the maximum pain level on July 22, 2013, is set at 6000.
Consequently, call options at 6100, 6200, and so forth will likely have no value at expiration. The same applies to put options such as the 5900PE and 5800PE.
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