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The option chain on the NSE website provides information about calls and puts on all strikes currently available for trading on a given underlying. Of most interest to traders is the build-up in open interest on the Nifty Index options. This week, we discuss how you use this information for your trading decision.
Floor and cap
You must observe four variables in relation to open interest (OI). OI for the near week and the next week options and the change in OI for the near week and the next week options. The OI in next week options is relevant during the week running up to the expiry of the near week options. That is, the build-up in OI in the next week options become relevant starting the previous Monday when the traders gradually close their positions on the current week options and move to the next week options.
It is typical for traders to check the near week call and put strikes that have the maximum build-up in OI. At the time of writing this article, with the Nifty Index at 21550, the maximum OI position was in the 21700 call and the 21000 put. Based on the premise that institutions typically sell options, this information suggests they expect the Nifty Index to trade between 21000 and 21700. In other words, the call strike with the maximum OI acts as a cap and the put strike with the maximum OI acts as a floor. Why? If the institutions are selling options, then the only way they can profit from the short positions is when the options expire worthless. That can happen only if the Nifty Index is lower than 21700 and higher than 21000.
But OI is cumulative unlike volumes. Therefore, a strike could have a high OI because of a large build-up the previous week, but not during the current week on the run-up to the expiry. That is why change in OI becomes important. Based on this variable, the 21800 call and the 21200 put seems to attract trader attention. What about the build-up in the next week options? The change in OI indicates that the traders are initiating fresh positions in the 21700 call and the 21500 put. This suggests a narrow trading range for the next week based on the current build-up in OI.
Optional reading
An indication of the cap and the floor for the Nifty Index is useful when you are initiating volatility trades. For instance, on the run-up to the Budget or any macro-level event. If you are betting on volatility exploding (increasing), you should initiate a long straddle or a long strangle. A long straddle is typically setup using at-the-money (ATM) options. But your choice of strikes for a long strangle could be based on the potential gains the position can offer if the Nifty Index stays within the cap and the floor indicated by the change in OI.
(The author offers training programmes for individuals to manage their personal investments)
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