- This article describes some of the core elements of options chain analysis and how they are deployed in the options market.
Option chain analysis uses a structured table listing all available call and put options for the underlying asset. The essence is to use certain parameters, known as the Greeks, to analyze each option’s price and identify trading opportunities and market sentiment.
To use options chain analyses for trading, certain core components of the strategy must be identified and defined. These are as follows:
- Strike price
- Call/Put options
- Volume
- Open interest
- Implied volatility
The Strike Price is the price at which the trader exercises the option and is usually listed in the middle of the price table that forms the option chain.
Call and Put Options are akin to long/short trade types. While the lingo uses “long trades” in FX, the options market refers to trades that aim to capitalize on a price increase as “Calls”. Trades that aim to profit from falling prices are called “Puts”, just as we have Shorts in the FX market. So, call/put options, in simplistic terms, refer to buy/sell trades in the options market. A call option is located on the left side of the options chain and gives the trader the right to purchase an asset at a specified price (but does not obligate the trader to exercise the option on expiry). A put option is usually located on the right side of the options chain table and gives the trader the right to sell the underlying asset, but not the obligation to exercise the option when the contract expires.
Volume refers to the number of contracts that are traded during the trading session. The contract consists of 100 units of the assets being traded. A high volume indicates high liquidity and active trader interest.
Implied Volatility refers to market expectations regarding an asset’s future volatility. Whenever implied volatility spikes, it indicates an impending directional movement in the asset. It can also indicate market positivity.
Open interest refers to the total number of contracts that remain outstanding after other contracts have been settled. In other words, it just indicates the number of contracts that are yet to be settled.
Since an options chain indicates where traders are basically applying their bets, knowing how to read the options chain (i.e. options chain analysis) is one of the best ways to analyze the options market for an asset and trade it accordingly.
In other words, it just indicates the number of contracts that are yet to be settled.
Key Components of Option Chain Analysis
The key components of options chain analysis that will be discussed below are:
- Open Interest (OI)
- Put-Call Ratio (PCR)
- Implied Volatility
1)Open Interest (OI)
When open interest is rising, it indicates stronger conviction among traders, accompanied by increased market participation (traders on the fence start jumping in). It also signifies that the prevailing trend is likely to continue. Open interest is on both the call and put sides of the options table.
When the Open Interest in a Call option is high, it indicates that the asset is near a resistance level. Here is an example to illustrate this. Assume that a stock index has various strike prices and open interest on its call options as stated below:
For example:
| Strike Price | Call OI |
| 22,000 | High |
| 22,500 | Moderate |
| 23,000 | Very High |
The table shows a large concentration of traders writing Call options at 23,000, more than any other price level. This indicates potential resistance at that price level.
On the other hand, a high open interest in puts indicates the asset is trading close to a support level. In this example below:
| Strike Price | Put OI |
| 23,000 | High |
| 22,500 | Very High |
| 22,000 | Moderate |
The open interest is highest at 22,500 than at any other price level. This means that there is a potential support level at 22,500.
2)Put-Call Ratio (PCR)
This is a formula that seeks to indicate the total open interest on the put options as against the total open interest on the call options.
PCR is calculated as:
PCR = Total Put Open Interest ÷ Total Call Open Interest
Interpretation
If PCR > 1
- It means that there are more open, unsettled put contracts than there are unsettled call options.
- In simple terms, it means more traders are bullish and are writing calls and not puts.
- This is an indication that the sentiment on the asset is generally bullish.
PCR < 1
- It means that there are more unsettled Call options that Put options.
- It simply means that traders are more bearish on the asset and are writing Put options more than Call Options.
- This makes the sentiment around the asset generally bearish.
3) Implied Volatility (IV)
Implied Volatility is a measure of an asset’s expected future volatility. Implied volatility can either be rising or falling.
- Rising Implied Volatility indicates that market uncertainty is increasing. It is also an indication that a major news event could cause a market upheaval, and that larger price swings are on the horizon.
- Falling Implied Volatility indicates a situation in which market stability is expected, usually due to a reduction in factors that induce market uncertainty.
How Institutional Traders Use Option Chains
The options market has less retail participation than the FX market. You get to see more of institutional traders in this space. Institutional traders use data obtained from options chain analysis to do the following:
- Identify support and resistance levels or zones.
- Track positioning of other institutions
- Assess the state of market sentiment
- Get estimates of the existing expiry ranges
- Develop hedging strategies
Many institutional desks monitor large concentrations of option open interest because these levels often influence short-term market behavior.
Limitations of Option Chain Analysis
Options chain analysis is a powerful tool for trading and analysis, but it is not a perfect system and is rarely used on its own.
- Options chain analysis does not account for sudden price changes driven by macroeconomic news or Black Swan events.
- Options chain analysis is not beginner-friendly. It requires a level of understanding to be deployed properly and successfully.
- Options chain analysis becomes less accurate as time decay sets in.
- The price information on options chains does not always reflect the true execution prices due to spreads, so it is mostly indicative.
- Option chains cannot assess the asset’s underlying fundamentals or any evolving technical patterns on its price chart.
- Option chains cannot detect market manipulation and other external factors that can affect prices.
Due to these limitations, options chain analysis should not be used on its own, but should be combined with market structure, price action analysis, and macroeconomic data.
Final Thoughts
Option chain analysis can provide information as to the positioning of institutional traders and their market sentiment. The metrics derived from options chains allow traders to obtain useful information about potential support and resistance levels. Due to some of its inherent limitations, option chain analysis must be combined with other forms of technical and fundamental analysis.