What is Option chain: Types of options, Components and how to use option chain data

Traders have to look at multiple places for multiple data points to decide which options to trade. An option chain addresses this challenge by providing detailed information about option contracts for a particular security or an index.

option chain and how traders can take advantage

To start share trading, a trader needs to open a trading account. These days, most share brokers provide a 3-in-1 account. It comes with a trading account, a demat account and a bank account. Once a trading account is opened, a trader can login to the share broker's website or mobile app and start trading.

A trader can trade in two segments in the equity market:

1) Cash segment

In the cash segment, a trader can decide to purchase shares of a specific company at a specific price and take delivery. 

For example, as of 7 July 2021, Reliance Industries Ltd. (RIL) shares were trading at Rs 2100. A trader can decide to place a buy order with the number of shares required (say 100). He will have to pay Rs 2,10,000 to take delivery of 100 RIL shares.

2) Derivatives segment

In the derivatives segment, a trader can get into a contract to purchase shares of a specific company at a specific price. But the delivery is done on a future date.

For example, as of 7 July 2021, RIL shares are trading at Rs 2100. A trader can decide to purchase a contract to buy RIL shares in the future. The contract specifies the standard purchase quantity (lot size of 250 shares in case of RIL) and the date (29 July 2021 – contract expiry date for July). The trader can decide on 29 July whether to take delivery of 250 RIL shares or let the contract expire.

Within the derivatives segment, a trader can trade in two instruments: futures and options. In this article, we will focus on options.

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Concept of options

To understand what equity options are, we can take the simple analogy of a term insurance plan. 

a) Contract: In a term insurance plan, the life insured and the insurance company enters into a contract. 

b) Premium: The insured pays a premium and the life insurance company issues the contract (life insurance policy). 

c) Happening of specified event: As per the contract terms and conditions, if a specified event happens (the insured’s death in this case) within the policy term, the insurance company will pay a specified amount (sum assured) to the nominee. If the specified event doesn’t happen within the policy term, the life insurance company gets to keep the premiums.

The above simple analogy of life insurance can be applied to equity options as follows:

a) Contract: In an equity option trade, the buyer and seller get into a contract to buy/sell a specified number of shares of a specified company at a specified price on a specified date. 

b) Premium: The option buyer pays a premium to the option seller. 

c) Happening of specified event: As per the terms and conditions of the option contract, if a specified event happens (the market price of the share goes above/below a specified price) within the contract term, the option seller will pay the difference between the market price and the specified price to the buyer. If the specified event doesn’t happen within the contract term, the seller gets to keep the premiums.

What is an option?

An option is a contract that gives the buyer the right but not the obligation to buy or sell a specified quantity of an asset (shares of a company or index) at a specified price by a specified date. 

Let’s illustrate this with an example. On 7 July 2021, Karan (a trader) buys an option that gives him the right to buy 250 shares of RIL at Rs 2100 per share by 29 July 2021 by paying a premium of Rs 57 per share.

Certain terms related to an option include:

a) Market lot: A contract specifies the number of shares to be bought. It is known as a market lot. In the above RIL example, the market lot is 250 shares. A buyer can buy one or multiple market lots.

b) Strike price: The share purchase price specified in the contract is known as the strike price. In the above RIL example, the strike price is Rs 2100.

c) Expiry date: The date by which the buyer should exercise the right to purchase the shares is known as the expiry date. In the above RIL example, the expiry date is 29 July 2021. Please note that the buyer has no obligation to exercise the right to buy. So, they can let the contract expire without exercising it. It means the buyer may drop the decision to buy RIL shares by 29 July 2021.

d) Premium: For entering into a contract, the option buyer has to pay the option seller a fee known as the premium. In the above RIL example, the premium is Rs 57 per share.

As seen above, the highlight of an option contract is that it gives the buyer the right but not the obligation to buy. So, a buyer may decide to let the contract expire without exercising their right to buy.

Types of options

A trader can buy two types of options, depending on whether they feel the stock price will go up or come down.

a) Call option

If a trader feels that the price of a particular stock will go up in the near future, they can buy a call option. This gives them the right but not the obligation to buy a specified number of shares of a specified company by a specified date by paying a specified premium.

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b) Put option

If a trader feels that the price of a particular stock will come down in the near future, they can buy a put option. This gives them the right but not the obligation to sell a specified number of shares of a specified company by a specified date by paying a specified premium.

Option chain

An option chain gives detailed information about option contracts for a particular security (for example, RIL shares) or a particular index (Nifty 50). An option chain is also known as an option matrix. Option chain information can be obtained from the NSE website. 

See the table below for RIL option chain for the July 2021 series expiring on 29 July 2021.

Table: RIL option chain for July 2021 series

(Source: www.nseindia.com)

Components of the option chain

The option chain has various components. Some of these include:

a) Option type

As can be seen from the above table, option chain data is divided into two categories. The left side represents the RIL call options data for various strike prices ranging from 2000 to 2200. The right side represents the RIL put options data for various strike prices.

b) Open interest (OI)

Open interest or OI represents the number of contracts traded but not exercised for call and put options for various strike prices. It represents the number of open positions till date for a particular series. For example, for the RIL 2100 strike price, the call OI is 11,528, and the put OI is 11,324. A higher OI for a particular strike price represents higher interest by traders for that particular strike price.

c) Volume

This represents the number of contracts traded for a particular day. For example, for RIL 2100 strike price, the call volume is 10,037 for 7 July 2021.

Table 1: How to read open interest and volumes together

Open interest (OI) and volume What it indicates
OI up and volumes up? The sentiment is bullish, long build-up
OI down and volumes down The sentiment is bearish, long unwinding

Note: Terms like ‘bullish’ and ‘long build-up’ mean buying interest by traders. Terms like ‘bearish’ and ‘long unwinding’ indicate that the upward move is not sustainable, and prices may reverse.

d) Last traded price (LTP)

It represents the price at which the last contract was traded. For example, for RIL 2100 strike price, the last call was traded at Rs 58 premium/share.

Table 2: How to read volumes and price together

Volume and price   What it indicates
Volumes up and price up The sentiment is bullish, up move is sustainable
Volumes up and price down The sentiment is bearish, and there is more downside
Volumes down and price up The sentiment is cautiously bullish. The up move rally may fizzle out if there’s no increase in volumes.
Volumes down and price down The sentiment is cautiously bearish. The down move may not sustain if there is no increase in volumes.

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e) Change (CHNG)

It represents the change in the price of a particular call or put option from the previous session’s closing price. A positive value (in green) represents an increase in price from the previous session’s closing price. 

A negative value (in red) represents a decrease in price from the previous session’s closing price. For example, for RIL 2100 strike price, for the call option, the change is –8.45, which represents a fall of Rs 8.45 from the previous session’s closing price.

Table 3: How to read open interest and change in price together

Open interest (OI) and change in price What it indicates
OI up and price down The sentiment is bullish, long build-up
OI up and price down The sentiment is bearish, short build-up
OI down and price up Short covering is taking place
OI down and price down Unwinding of long positions is taking place

Note: Long build-up means traders have made new purchases; unwinding of long positions means traders have closed their earlier long positions; short build-up means traders have put in new sell orders, short covering means traders have closed their earlier sell orders.

f) Bid quantity and bid price

The bid quantity represents the number of buy orders placed by traders. The bid price represents the price that buyers are willing to pay. For example, for the call option for RIL 2100 strike price, the bid quantity is 750 shares and the bid price is Rs 57.95 per share.

g) Ask quantity and ask price

The ask quantity represents the number of sell orders placed by traders. It represents the price that sellers are willing to accept. For example, for the call option for RIL 2100 strike price, the ask quantity is 1000 shares and the bid price is Rs 58.00 per share.

That was all about the call options data on the left side. Similarly, you can read and analyse the put options data on the right side.

How traders can take advantage of option chain data

Option chain data is very useful for traders while taking important trading decisions. It helps them to:

1. Identify key stock levels to keep a watch on.

2. Identify key support and resistance levels for a stock/index. (If both are moving higher it indicates a bullish move; if both are moving lower it indicates a bearish move.)

3. Identify sentiments of market players with components like OI, volume, change in price, etc.

4. Check for liquidity by looking at OI and volume.

Last words 

All of the above option chain data helps a trader to decide which stock option to trade, whether to buy a call or a put option, at what strike price, etc. For a trader, option chain data can spell the all-important difference between a profitable or a loss-making trade.

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