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How to interpret Option strike concentration

stock market
12 Feb 20206 mins readBy MOFSL

Option trading in stocks and on indices is all about identifying the right strike price. The strike price is the price at which you contract to buy or sell a particular stock. For example, if the stock of Hindustan Unilever is quoting at Rs.1200, and if you are expecting a 5% increase in price, then you need to buy an HUVR call option with a strike price of 1220 or 1240. It is only in these strikes that you will get the best combination of intrinsic value and time value. On the contrary, if you choose to buy a 1340 call option just because the premium is negligible, then you are unlikely to make any money. Hence selection of the strike price is critical.
An important choice that you need to make when it comes to option strikes is whether you must go for an ITM option, ATM option or an OTM option. The second choice is what should be the maximum premium you should be willing to pay for a particular strike. While these are important choices, there is another important consideration that traders focus on. It tells how the concentration of strikes is changing and what it means for the market.

November option strikes for Reliance Industries



The above table is also referred to as the Options Chain. This data refers to how various strikes of Reliance options have behaved for the November contract. With just 1 day to go for the October contract, we have preferred the November contract to give a clearer picture of Options concentration. Here are 5 things to read from this data..
 
Are we seeing signs of range-bound strangles built up...?
This is a classic give away of a range bound trade. A short strangle is normally a range-bound trade where you sell higher calls and sell lower puts. This is an indication that the stock price is likely to remain in a range. Large traders and institutions have the confidence to write strangles only when they believe that the stock is unlikely to cross a particular range. These strangle ranges are quite obvious from these OI concentration trends. It clearly shows the view that institutions and knowledgeable traders are taking on the stock.

Is the strangle range shifting gradually?
This is another important trend that is underlying each stock. There are stocks that are in an uptrend and there are stocks that are in a downtrend. What really underscores this trend is the moving of the strangle range. If you see stock prices moving up but you also find the strangle range moving up it is a clear sign that the uptrend is being confirmed by the strangle traders. The reverse holds true in the case of down trending markets when the strangle range gradually moves downward.

Is there any action in deep OTM option strikes?
This is normally a very major give away for a stock which is about to see sharp price movements. Normally, before a major positive announcement you can see some gradual accumulation happening in deep out of the money calls. On the other hand, when a stock is about to crash, you see accumulation in deep OTM puts. Normally, in most cases action is visible ahead of key events in deep OTM calls and puts.

How is the OI changing
This is a key indicator. It is not just the overall OI but how much the OI is changing and how rapidly. After the sharp up move in PSU banks, SBI has seen aggressive accumulation in deep OTM call options in the November contract with most of the OI accretion happening in a single day. Normally, more aggressive the accumulation in OTM calls, the more likely that the rally could sustain for some more time.

Total daily volumes and total OI of calls and puts
This is another important indicator of which way the market is trending. Normally, when the market is trending upwards for a stock, you find the volumes in calls substantially higher than the puts and also the OI accumulation of calls more aggressive compared to puts. That is a trend that is visible in the November contracts of most of the PSU banks indicating that there may still be further upsides.

 

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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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