January 11, 2019

How I analyse NIFTY options open interest data

Every option trade requires a buyer and a writer (seller) both holding diametrically opposite views about the direction of the market. So one has to be bullish and other has to be bearish (otherwise a trade will not happen).

An option buyer has limited losses but can benefit from unlimited profits. The option writer needs to invest large sums of money for limited profits while exposing himself to risk of unlimited losses.

So why will someone write options? The reason is PROBABILITY and the way the option product is structured. It is something like insurance you buy in order to mitigate the risk of some unforeseen event happening. If nothing happens, you lose the premium otherwise you can get a large payout.

In case of options, it is time decay which is the option writers income. So if nifty is at 11000 and I am expecting a rangebound market, I can write a 10500 put and 11500 call. These levels are chosen depending on where the support and resistance is. If I am correct, by expiry the entire premium I collect is my income and the buyer has lost.

Another example... assume trend is up and nifty is at 11000 - good support at 10500. As an option  writer I will take a bet that 10500  will not break this expiry and so I will write puts.

The option writer and the buyer (usually retail) have always opposite views so this makes a trade possible.

When tens of thousands of trades happen, positions happen to cluster around certain strike prices. This data is easily available on the web and I use the Bloomberg site as an example - the link is here.

Chart as of  10-JAN-2019 is shown below. You can see highest concentration around 10500 PE and 11000 CE. The open interest is roughly the same meaning possibility of limited upsides (as markets are closer to 11000 than 10500). A small correction cannot be ruled out.

Note you have to focus on only the bars with highest value.

What can happen in future?

- if option writers expect a correction, they will start exiting their short positions in puts and start writing OTM calls
- if they do not expect 10500 to break, they will continue to write more puts at that strike or lower. But if the markets break 10500, they will hedge their position by shorting nifty futures. Because of this, you will sometimes see an ITM option has very high open interest. It just means the writers have not  squared off their positions.

A word on  hedging.

Most positions are hedged and it is impossible to know how a hedge is created (at least for me). For example, I am short 11000 CE and long 11100 CE... the strategy gets me a max profit of 20 Rs and max loss of Rs.80. From the time I have taken this position, markets have been rangebound and so far I am enjoying benefits of time decay.



NOTE: all above is my view and I may be wrong.

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