OPTION CHAIN ANALYSIS

What is open interest? 

Open interest refers to the total number of options or futures contracts that are still active and have not been closed, expired, or exercised. It shows how many contracts are currently being traded. Open interest is also sometimes abbreviated as OI. 

option chain analysis.

When a buyer and a seller come together to open a new contract, the open interest increases by one contract. On the other hand, if both the buyer and the seller close their contract position, the open interest decreases by one contract. 

However, if a buyer or a seller transfers their position to another buyer or seller, the open interest does not change. 

In summary, open interest tells us how many contracts are still active and being traded, and it changes when new contracts are opened or existing contracts are closed. It appears that the concept of open is simple but puzzling. Don't worry; the following example will clear up any confusion you may have regarding open interest. 

Day	Activity	Open  Interest	Change  in OI
Day1	‘A’ buys 1 option and ‘B’ sells 1 option contract	1	1
Day2	‘C’ buys 3 options and ‘D’ sells 3 option contracts	4	3
Day3	‘A’ sells his 1 option and ‘D’ buys 1 option contract	3	-1
Day4	‘E’ buys 3 options from ‘C’, who sells his 3option contracts	3	0

 The table above depicts, both "A" and "B" establish fresh positions on the first day, resulting in the creation of one open interest. In other words, "B" writes a contract, and "A" purchases it. Both 'C' and 'D' created three additional positions on the second day. As a result, open interest climbs to four contracts, and the change in open interest is three (3 new positions established today). Look at the trades on the third day; 'A' and 'D' both squared off their previous holdings. As a result, open interest will be reduced by one contract. Finally, on the fourth day, ‘C’ leaves from his holding by transferring all his three number of contracts to a new trader, ‘E’. As a result, there will be no change in open interest, and the total outstanding open interest will stay the same, i.e. three contracts.

What is volume? 

Volume is the total number of shares or contracts traded during a single trading session. Volume simply refers to the quantity of transactions. It also displays how active an option or futures contract is. Volume is occasionally used by traders to gauge the strength of a price shift. More volume in the derivative contract suggests more liquidity. It means that there are enough buyers and sellers in the market. Before making any trading choice in the near term, it is usually essential to examine the contract's liquidity. 

Anyway, volume appears to be very straightforward, right? Please be patient! Most new traders get confused by open interest and volume. Let we first explain this topic. Look at the analogous scenario below – 

Day	Activity	Open  Interest	Volume
Day1	‘A’ buys 1 option and ‘B’ sells 1 option contract	1	1
Day2	‘C’ buys 3 options and ‘D’ sells 3 option contracts	4	4
Day3	‘A’ sells his 1 option and ‘D’ buys 1 option contract	3	5
Day4	‘E’ buys 3 options from ‘C’, who sells his 3 option contracts	3	8

 At first, both 'A' and 'B' establish a new position, and so open interest and volume become one. Similarly, on the second day, 'C' and 'D' make additional deals, bringing total open interest and volume to four. On the third day, both 'A' and 'D' square off their previous positions, reducing open interest to three. However, since transactions occur between them, the total volume equals five. Finally, 'C' exits the market by selling three contracts to a new trader, 'E'. As a result, while open interest remains constant, final volume increases to eight since three transactions occurred between them. 

Important lessons: 

We have already covered open interest and volume with examples. The following points will help you differentiate open interest with volume. 

• In contrast to open positions, volume represents the number of transactions. 
• Volume always rises, although OI can rise or fall. 
• Open interest reveals a contract's level of activity. 
• Volume indicates how liquid a specific contract is.
• Professional traders use volume to determine a trend's underlying strength. 

Interpretation of Open Interest Data 

Open interest is a measure of the total number of outstanding contracts for a particular futures or options contract. It indicates the total number of contracts that have been bought or sold but not yet settled by delivery or an equal-and-opposite trade. Following are some uses of open interest: 

1. Trend Analysis: A specific futures or options contract's trend can be examined using open interest. In general, it is regarded as an upward trend when open interest rises along with prices. On the other hand, if open interest is falling while prices are rising, this can be a sign of a possible price reversal. 

2. Liquidity: A market that has a lot of buyers and sellers is said to be liquid when there is a high level of open interest. It is simpler for traders to enter and exit positions on a market that is liquid since it typically has narrow bid-ask spreads and cheap transaction costs. 

3. Support and Resistance: Open interest can also be used to identify potential support and resistance levels for a particular futures or options contract. For instance, if open interest is high at a certain price level, it can mean that traders are making purchases or sales at that level aggressively, making it a possible support or resistance level. 

4. Option Trading: Since it indicates the number of outstanding option contracts that could potentially be exercised, open interest is particularly crucial in the trading of options. When an option contract has a high open interest, it may be a sign that there is substantial interest in that contract, making it a potentially appealing alternative for trading. 

You studied open interest and volume in the previous chapter. It's time to examine open interest in order to determine the current state of the market. It is a very useful tool for determining how prices are moving. For a better approximation of the derivative market's price movement, one should take into account data from both futures and options contracts. As a result, we will first talk about how to understand futures OI data, then options OI data, and lastly, how to combine them to determine the market trend. 

Interpretation of futures open interest data

While examining the futures open interest data, four situations can be visualized. These are – 

1. Price Increase + Rise in Open Interest 

There is potential for price rise. More traders enter into long positions as the price rises, increasing open interest. It suggests a bullish trend. 

2. Price Decline + Development in Open Interest 

There is potential for price decline. More traders enter into short positions when the price declines, increasing open interest. It suggests a bearish sentiment. 

3. Rise in price + Drop in open interest 

There is weakness in pushing the price higher. When prices rise, short sellers believe that the price will rise further and quit their positions, which causes open interest to decline. It denotes either a bullish reversal or short covering. 

4. Price Decrease + Fall in Open Interest 

There is weakness in the price decline. When prices drop, buyers fear that the price will fall further more and sell their positions, which reduces open interest. It denotes a bearish reversal or long unwinding. 

Interpretation of options open interest data 

Futures open interest may be easily and quickly analysed. However, it can be challenging to understand option open interest. Let's attempt to provide a clear and concise explanation of the interpreting process. I'll go over the reasoning behind this interpretation as well. Let's first analyse the call and open interest separately before combining them to forecast the price movement. 

First, let's examine the call open interest statistics. The interpretation is quite similar to that of futures OI. While assessing the call OI data, you will also obtain four scenarios below. 

1. Rise in CE + Rise in OI

The rationale for raising the call premium is strong. More traders enter the trading floor as the call premium rises, increasing the build-ups of open interest. It suggests a build-up of long calls or bullish sentiment. 

2. Drop in CE+ Increase in OI 

There is potential for falling the price of call premium. Open interest rises as additional option sellers enter the market to implement trades and desire the price to drop even further as the call option's premium decreases. It alludes to what is known as short build-up or bearish sentiment. 

3. Increasing CE+ OI decline 

There is resistance to raising the call price. When the call premium rises, the call writers cover their positions out of fear of raising the price, which results in a decline in open interest. It denotes call short covering or a bullish reversal. 

4. Drop in CE+ OI decline 

There is a vulnerability in lowering the call premium. As the price of a call option declines, buyers reduce their open interest because they decide to sell their positions out of worry that the price will continue to fall. It signifies a bearish reversal or call long unwinding. 

It appears simple and engaging to analyse call open interest. Given that they are identical, if you enjoyed it, you will love the interpretation of put open interest as well. Let's look at it. 

1. Increase in PE + Rise in OI 

There is support for raising the put premium. More traders enter the trading floor when the put premium rises, which results in a building of open interest. It indicates put long build-ups or a bearish sentiment. 

2. Drop in PE+ Increase in OI 

There is strength in falling the put premium lower. Open interest rises as more option writers make trades and expect the price to continue falling as the put option's premium decreases. It indicates put short build-up or bullish sentiment.

3. Increase in PE+ Reduction in OI 

The upward movement of the put option price is weak. Put writers cover their positions when the put premium rises out of a fear that the price will rise, which reduces open interest. It alludes to put short covering or a bearish reversal. 

4. Drop in PE+ OI decline 

There is weakness in lowering the put price. Put option buyers quit their positions as the price of the option drops out of fear that it may fall even further, which reduces open interest. It suggests a bullish reversal or put long unwinding. 

The interpretation of open interest appears fantastic. To assess the total market sentiment, we will now merge the call and put OI. Only the market sentiment will be confirmed if both options reflect the same market emotion, such as bullish or bearish. Did I confuse you? Not to worry! To avoid confusing you any further, let me blend the two interpretations first. If you have any questions, the following example can help you to understand them. 

1. Call long build-up + Put short build-up 

The price can be moved higher. The put writers simultaneously push the price upward while the call buyers want the market to rise. It alludes to the bullish sentiment. 

2. Put long build-up + Call short build-up 

The price can be moved down with some force. Put purchasers want the market to decline, and call writers want the price to decline even further. It suggests a bearish sentiment. 

3. Call short build-up + Put short build-up 

There is limited room for price movement in either direction. The put writers support the price falling while the call writers prevent the price from rising. This is a market that is completely range-bound or sideways. 

4. Put short build-up + Call long liquidation

There is less force in moving the price upward. The call buyers' decision to book profits could cause a slight correction, but the put writers will prevent the price from dropping. It signifies a sideways market with a positive tilt. 

5. Call short build-up + Put long liquidation 

There is less intensity in moving the price downward. The price does increase because of put long unwinding, but the call writers suppress this increase. It represents sideways market with a negative bias. 

These five types of emotions are typically displayed by the market. Additionally, the market can occasionally become quite volatile. A volatile market is one that has abrupt price changes, which can go both up and down. Markets typically experience this type of movement because of quick news events, such as elections, budget sessions, and sudden announcements of significant government policies, among others. An index called India VIX is used to measure the market's level of volatility. Market volatility is anticipated to remain high if the index value is high, and vice versa. 

In this manner, the intraday market trend can be determined by examining futures or options open interest. You can also predict the short-term trend if you routinely monitor the OI building on a given security. When future and option data show a bullish attitude, go for opening a long position; if both interpretations point to a bearish emotion, open a short position. Avoid trading in a sideways market unless you have a sound sideways market approach. It is sometimes better to wait for an opportunity than to enter a bad trade. 

Identification of Support and Resistances Using Open Interest Data 

So far, the interpretation of future open interest and options open interest has been done in a methodical manner. But did you know that? Options open interest is a fantastic tool for identifying support and resistance. To determine this, look for a high level of open interest on both the call and put sides. The highest call OI implies a strong resistance for that expiry, while the biggest change in OI is thought to constitute intraday resistance. Otherwise, take the biggest change in call OI to be resistance1, and the highest outstanding OI to be resistance2. Similarly, the biggest OI on the put arm may work as expiration support, whilst the highest shift in OI may act as intraday support. Furthermore, biggest change and remarkable OI might be considered for support1 and support2, respectively. When the peak and change in OI coincide, it is considered to as strong support or resistance. 

Now, you may be wondering why the highest call and put OI are regarded as strong resistance and support. Let me explain why. Consider maximum call OI

initially. The call sellers took positions on a specific strike because they anticipate the price will not rise over that level. As a result, it will function as a barrier until the holdings are liquidated. The same argument may be employed on the put side as well. The put writers believe that the price will remain above that level until their bets are covered. 

Support and resistance, however, may also break. Let's look at an example to understand how a support or resistance breaks. Consider that the Nifty is trading at 17700 and that the highest call OI is at 18000 strikes, while the greatest put OI is at 17500. The Nifty will therefore encounter resistance above 18000 and will find support at 17500 levels, according to this. Let's say the cost of 17500 put options is Rs. 60 at the start of the expiration. This implies that the put writers will lose money if the Nifty drops below 17440 (17500 – 60). The index will fall around 17400 levels as a result of the put seller being forced to square off their bets. 

The highest positions, however, were taken by call sellers at the 18000 strike. If the call premium is ₹40 for 18000 strikes at the beginning of the expiry, the call writers will be at breakeven when the index reaches at 18040 (18000 + 40). Beyond that point, option sellers who are short covering will push the Nifty higher to 18100 or more. Supports and resistances are thought to break in this manner over time. 

 Examples 1:

The interpretation of open interest for futures and options appears to be quite simple and exciting on paper. But is it really that simple on the market? Let's examine a few instances. Real option chain data for several market conditions are shown here. Example 1 

It is a chain of Nifty options with a 2nd March 2023 expiration date and the screenshot was taken during the market hour on 27th February 2023. At that moment, the index's spot price was 17,310 (rounded off). To determine the direction of the market, first consider the call OI, then the put OI, and lastly combine the two.

Open Interest

The call open interest 

The call OI shows a significant drop in call premium and a significant increase in open interest. According to OI interpretation principles, call option short build-ups have occurred, which indicates a bearish sentiment.

Call Short

The put open interest 

On the other hand, open interests were simultaneously added to OTM put options and put premium increases. Trading seems to have resulted in long positions via put options. The ITM (In-The-Money) put options also exhibit outstanding short coverage. Put long and short covering both point to a negative market outlook. Hence, by combining call and put options, it can be predicted that the index would decline soon, indicating that the market may continue to be quite bearish.

Put Long

Example 2: 

The Nifty option chain shown below was also in effect on 29th September 2020, when it was trading at 11,228 (rounded off). The information relates to OI building for the index's 1st October expiration.

Option Chain

The call open interest 

Examine the call option side initially. Both the open interest and call option price have significantly increased. Nothing but extraordinary buying in the call option is being done here. The volume indicates that option traders are diligently purchasing options. If call options are being purchased, this indicates a bullish perspective.

Call Short Covering

The put open interest 

Keep an eye on the put side right now as there are more open interests and a declining option price. It looks that the put option traders have taken a short position in the index. The huge volume in this instance also suggests that the writers of the put are very active. As a result, traders of call and put options want the price of the Nifty to increase. Massive short coverage in at-the-money and in-the-money call options have also occurred, pushing the index higher. If no overnight breaking news materialises, the index may therefore continue to trend strongly upward.

Put Short Build Up

Example3: 

You have seen the option chain for markets that are moving, or when market sentiment is strongly bullish or bearish. The two option chains described in the previous two examples belonged to the Nifty index. Now, let's look at a stock option example. See the option chain data for ASHOKLEY below. Data was collected on March 3, 2023, and it will expire on March 29, 2023. Even though there isn't a lot of open interest build-up, attempt to comprehend the potential interpretations. Prior to 2021, the NSE option chain showed open interest in numbers of shares of that specific security. Open interest is now displayed as number of contracts. If you want to view the open interest in the quantity, you simply multiply it by the lot size, which is 5,000 for ASHOKLEY. This explains why the option chain for ASHOKLEY appears to have sparse open interest building.

Short Build Up

The call open interest indicates that writing occurred, and the put open interest also indicates that put writers were active. Call writers will prevent price increases and put sellers will prevent ASHOKLEY price declines. The stock is therefore anticipated to move in a range-bound scenario for the upcoming trading sessions.