Option Chain Analysis: The Hidden Supports & Resistances
Open Interest and Volume
Traders use many types of market data to make trading decisions. Two items that are often studied but sometimes misunderstood are volume and open interest. Volume, as the name implies, is the total number of contracts traded during a time period. Often, the volume is stated on a one-day basis but could be stated per week, month, year, or otherwise. Once a new period (day) begins, the volume begins again at zero. Open interest is the number of contracts that have been created and remain outstanding. Open interest is a running total.
When an option is first listed, there are no open contracts. If Trader A opens a long position in a newly listed option by buying a one-lot, or one contract, from Trader B, who by selling is also opening a position, a contract is created. One contract traded, so the volume is one. Since both parties opened a position and one contract was created, the open interest in this particular option is one contract as well. If later that day, Trader B closes his short position by buying one contract from Trader C, who had no position to start with, the volume is now two contracts for that day, but open interest is still one. Only one contract exists; it was traded twice. If the next day, Trader C buys her contract back from Trader A, that day’s volume is one and the open interest is now zero.
Price, Volume & Open Interest Analysis
Finding Supports and Resistances: Data Reading
Option Chain Data For Powergrid on 15/10/2020. Powergrid price at the time of writing was at 156.
The first step is to find the strike where most of the open interest positioning is, In the above case, it can be noticed for Calls, maximum option writing is at 170 strike followed by 165 strike. Similarly, for Puts, maximum option writing is at 150 strike followed by 155 strike. This implies that at the above strikes, many professional traders have written Call & Put options, and thusly, these levels become very pivotal.
Observe that huge open interest is usually built at strikes that are OTM. As OTM Calls have strikes that are above the underlying price, the strike price of OTM Calls often acts as resistance for the underlying price (marked in red). Similarly, as OTM Puts have strikes that are below the underlying price, the strike price of OTM Puts often acts as a support for the underlying price (marked in blue).
As 170 Call and 150 Put have maximum OI, these are the strongest resistance and support. This data can be interpreted as market participants expect Powergrid to move in a range of 150 and 170 for the current expiry. However, keep in mind that with time, this can change.
What happens when one of these levels is breached. Well, let’s take the case of immediate support and resistance - 155 and 165. If the underlying goes below 155, Put writers (Put writers are bullish) could start unwinding their positions as their profitability would start reducing. This unwinding of bullish positions could cause the underlying price to head lower towards the next support of 150. If this Put unwinding is also accompanied by Call writing at higher levels, this is an even more bearish signal. On the other hand, if the underlying moves above 165, Call writers (Call writers are bearish) could start unwinding their positions. This unwinding of bearish positions could cause the underlying price to head higher towards the next resistance of 170. If this Call unwinding is also accompanied by Put writing at lower levels, this is an even more bullish signal.
Using Option Chain to identify shifts in the Trend of the underlying
Other than utilizing Option Chain to identify regions of Support and Resistance, it can likewise be utilized to discover the implications of movements in Support and Resistance, as and when they happen. The direction in which support and resistance are moving tells a lot about the overall direction of the underlying instrument. To do this, one must screen the changes in OI tab for both Calls and Puts. Keep in mind that the entire Option Chain must be monitored and not just the options that are OTM.
If both Call and Put option writers are reducing their positioning in lower-priced strikes and are increasing their positioning in higher-priced strikes, it means supports and resistances are both shifting higher. This is an indication that the trend of the underlying is strengthening. On the other hand, if both Call and Put option writers are reducing their positioning in higher-priced strikes and are increasing their positioning in lower-priced strikes, it means supports and resistances are both shifting lower. This is an indication that the trend of the underlying is weakening. On the other side, supports moving higher and resistances moving lower, or the other way around shows uncertainty about the trend of the script.
Note: Option Chain Analysis is not a substitute for other forms of analysis, such as Fundamental and Technical analysis. Instead, it must be used to complement the other forms of analysis, especially when building positions in options. Taking trading decisions just based on observations made from the Option Chain data can be quite risky.
Source: Trading option greek by Dan Passarelli