Understanding open interests and option contracts

Please explain the importance of open interest in options. Also explain the reason for saying in your Monday's column that “If the price and open interest decreases, that also signal bullish outlook.” - M.A. Samuel

Before getting into details of open interest, let us understand call and put options.

Call option: It is a financial instrument between two parties – the buyer and the seller. It gives the buyer the right but not the obligation to buy an agreed quantity of a particular stock (the underlying) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller (or writer) is obligated to sell the stock should the buyer so decide. The buyer pays a premium to seller for the right. The buyer of a call option wants the price of the underlying instrument to rise in the future while the seller wants the price to fall.

Put option: It is a contract between the buyer and seller that gives the buyer the right but not the obligation to sell an agreed quantity of a stock (the underlying) from the seller of the option at a certain time (the expiration date) for a price (the strike price).

The seller (or writer) is obligated to buy the stock. The buyer pays a premium to the seller for the right. The buyer of a call option wants the price of the underlying instrument to rise while the seller wants the price to fall. The buyer of put option wants the price of the underlying instrument to fall in the future while the seller of the put options wants it to rise.

If one thinks the share price is likely to go up, he would either buy a call option or sell a put option. Similarly, if one thinks that the price would fall, one would either buy a put option or sell a call option.

The loss for the buyer of the option (either call or put) is limited to the extent of the premium paid, while it could be unlimited for the seller of the option (either call or put). The maximum profit is limited to the extent of premium received for the seller (either call or put).

Open Interest: Open interest is the number of options contracts that are not closed or delivered on a particular day. In other words contracts that have been traded but not yet liquidated either by offsetting the trade or by exercising the right.

When one buys or sells an option, the transaction needs to be entered as either an opening or a closing transaction. If one buys 10 Nifty 5500 calls, one is buying the calls to open. That purchase will add 10 to the open interest figure. If the investor wanted to get out of the position, the investor would sell those same options to close and open interest would then fall by 10.

A lot of traders misunderstand that buying a put option is short and buying a call is long. One can go long or short on put/call options.

Theoretically, a rise in share price along with rise in open interest of call option (or fall in put open interest) indicates a positive bias; a rise in price but fall in call open interests (or rise in put open interests) suggests profit booking, indicating a bearish signal or limited upside to the stock.

A fall in share price along with rise in put open interest (or fall in call open interest) indicates a bearish signal. Similarly, a rise in price but fall in put open interests (or rise in call open interests) indicates a positive bias or limited down side for the underlying.

However, practically, the contrarian (read seller of the option) makes money most of the time, as they have deep pockets. As they take the maximum risk, (as their profit is limited only to the extent of premium collected from the buyer of the option), seller ensures profit.

Price and open interest fall: We had mentioned that “If the price and open interest decreases, that also signal bullish outlook. It is because, generally, when negative news disseminates, the share price of particularly company falls and open interest rises due to fresh accumulation of short positions.

Declining open interest along with fall in share price means that the market has digested the news, which implies that the prevailing negative price trend is coming to an end, as there is no fresh money is entering for further short creation. It denotes that the worst is probably over for the stock.

I have bought one lot of Shriram Transport Finance Corporation Ltd (June series) at Rs 865. Please explain its short and long-term prospects. - R.S. Kumar

Shriram Transport Finance: The outlook remains negative for the counter. Only a close above Rs 813 would change the outlook positive for the stock. It faces strong resistance at Rs 698 and the next at Rs 772. If the current trend sustains and if it breaches Rs 609, Shriram Transport Finance could slip to Rs 573 and even to Rs 467.

F&O pointers: The stock saw a marginal accumulation of long positions on Friday. Options are not active.

Strategy: Exit. If you are willing to take risk, keep the stop loss at Rs 609, and try to exit at higher levels with trailing stop loss. The stock did not trade in the range you have mentioned.

I have short position on Bhushan Steels June at Rs 420. What is the prospect for the stock? — Anil Jahagirdar

Bhushan Steel: The stock remains negative for the stock. Bhushan Steel finds immediate support at Rs 412. A close below Rs 412, could drag the stock towards Rs 382. A conclusive close below Rs 361 would change the outlook completely negative.

F&O pointers: The Bhushan Steel June futures added fresh short positions on Friday. Options did not see any trading.

Strategy: Hold your short position with a tight stop loss at Rs 420, your entry level.

NOTE: The analysis and opinion expressed in this column are based on F&O data available at this point of time and on technical analysis based on past price movements. There is risk of loss in trading.

(Feedback may be sent to > f&o@thehindu.co.in or >blfuturesoptions@gmail.com )

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