Options trading strategies
lastest update - 28 July 2016
How to track PCR & open interest to trade better in Options?
Nearly 84 per cent of the trades on National Stock Exchange take place in options. Delivery cash volume accounts for less than two per cent of the total traded volume during the day. With such high levels of trading taking in the options segment a trader who does not trade in these instruments should still know the basics of what options data are signalling. Generally movement in stocks starts in the option market which is, followed by futures and then the cash market. Transfer of movement between these markets is a result of arbitragers who search and make money on mispricing opportunities.
The number of traders who have taken a bet on the market is represented in the ‘Open Interest’. The following two techniques or strategies will help to determine the possibility of a change in direction of the stock or market and assist trader to make good money in short span of time while trading in options. How trading happens in Options? If a trader believes that the price of a stock or an index is likely to go up he buys a ‘Call Option’. If his analysis shows that the price is going to fall then he buys a ‘Put Option’ to gain from the opportunity. Prices of call options rises if market goes up and falls if it stays at the same level or falls. In the case of put options their prices rise if market falls and they lose value if markets are flat or rise. The number of traders who have taken a bet on the market is represented in the ‘Open Interest’. Armed with this basic information we shall now look at certain ratios which determine the possibility of a change in direction of the stock or market. There are two ways of calculating Put Call Ratio(PCR) . First is by using the traded puts and call options during the day and the second is by using the open position of calls and puts. The ratio is arrived by dividing the number of traded Put Options (or open interest in puts) by the number of traded Call options (or open interest in calls). In essence it gives an idea of number of traders who are bearish as compared to those who are bullish.
How PCR ratio helps trader to make money? The ratio helps in gauging the sentiment of the market or the stock. This facility of judging the sentiment is not possible in the cash or the futures market as bulls and bears cross each other out with each transaction. However, in options the bulls can trade separately by taking long positions by buying calls and bears can trade by buying puts. There are two ways a trader can use the ratio. The first is the obvious one where if the ratio increases, that is there are more traders buying puts than those buying calls it is interpreted as more traders are expecting the stock or the market (in case of higher put in index options) to go fall. Similarly, a lower Put Call ratio (traders buying more calls than puts) would mean that the market is likely to move higher.
However, professionals use the second one, which is using the ratio as a contrarian indicator. The general belief in the market is that retail investor generally buys options and institutional or professional trader generally sells options, it is better to trade on the side of the professionals. This means that if the if the Put Call Ratio is high, more retail is betting on the market going down, then a professional trader would bet on the market going higher. For example - On June 30th 2016, Put Call ratio of Nifty stood at 1.365 indicating higher concentration of bears who are accumulating puts. Nifty on this date was 8,204. On July 1, 2016 the ratio changed to 1.64 with Nifty closing at 8,287 signalling that more retail traders were betting on the market going lower. At a Put Call ratio of 1.64 nearly near six out of every 10 trader was betting that the market was going down. However, within a week the market shot up and was trading close to 8,600 mark, trapping the bears in the process.
Second example - A similar trade was witnessed in Bank Nifty over where the Put Call ratio touched a level of 1.7 by mid of July but against popular belief the banking index led the overall market rally. The key in trading on this strategy is in knowing the historical levels of the Put Call ratios, where the extreme levels are and what are the average levels between which the market gyrates. One should be on the lookout for the extremities in the market. Every market indices and stocks will have different average levels and extreme levels so it would be difficult to generalise. But a rule of thumb is that a put call ratio of 0.7 is extremely over bought and a level of 1.33 is over sold. What is Open Interest and how to make use of it for trading? One of the least looked after number in an option sheet is the number of traders who have placed their bets, which is captured in the Open Interest. On a standalone basis Open Interest means little on its own, but along with price and volume it gives a good indication of where the market is headed. Consider if a stock price is moving higher it should ideally be adding open interest in call options at the same time the option price should be increasing. But if the open interest falls and option price does not increase at the same pace as the stock, it is an indication of profit booking and very soon the rally would be over.
Assume Nifty 8,500 call trades at 120 with an open interest of 150,000 and the Nifty trading at 8,450. If Nifty rises to 8,480 so does the call option to say 135 and open interest at 170,000. Now if 8,500 is a resistance level which will be difficult to surpass professional would start booking profits. Thus even if Nifty touches 8,500 the call option could remain around 135 levels and open interest would start falling to say 140,000. This would be an indication that the rally is nearing its end. Similarly, a bottom is expected to be formed when open interest in put option reduces though price might continue to fall. Open interest rising along with volume and price is a strong bullish indicator while open interest and volume rising with price falling is strong bearish indicator. Various combinations of these three are used by traders to form a view of where the market is headed. Professional traders use this to get an idea if the stock or index is witnessing a build-up which can be seen if open interest in a stock is increasing but there is no movement in the stock price. Though there are numerous strategies in options trading knowing the basics by watching the above mentioned data can be helpful in judging the probability of the market direction. Trading after all is about dealing with probabilities and uncertainties and profiting from it.