How To Convert Raw Option Chain Data Into A Trading Strategy?

The CSR Journal Magazine

Turning the raw option chain data into an actual trading strategy requires going through three stages: reading positioning information, understanding the volatility message, and constructing a trade with clearly defined risk boundaries. In this article, we will get in details. 

Read the open interest next to the price

Begin with the open interest (OI) and analyse it next to the price. Let’s assume Nifty is somewhere near 25,000. If the 25,000 CE (call option) strike increases the OI while the premium continues to decline, it indicates that option sellers are continuing to sell calls. It is usually a sign of the resistance level for that expiry. 

Now, look at the 24,800 PE (put option) strike. Rising OI, along with an unchanging premium, indicates that option sellers are supporting this level. Put it all together, and you have a rough estimate of the trading range for the week based on the location of major money positions, not on some chart pattern. 

A put-call ratio (PCR) greater than 1.3 near the support strike level confirms that the floor is defended, while a PCR close to 0.7 near the resistance level confirms that the ceiling will also stand.

Understand what implied volatility is pricing in

The next thing to consider is the implied volatility in the option chain. This is the stage that most people tend to miss. IV does not behave the same way in relation to all strikes. 

Several days before a major event, like an RBI policy review or results announcements, pay attention to how out-of-the-money puts become more expensive compared to out-of-the-money calls. Bank Nifty IV jumping from 14 to 19 within a short period of time indicates the demand to hedge against the risk. 

It means two things: first of all, there is the expectation of some unusual move, and second, immediately after the event, the IV falls very quickly regardless of the direction of the price change.

Convert your view on the market into a trade idea

And now we come to turning raw numbers into trade ideas. If your expectation is that the price will stay within a certain range and the IV is already high prior to the event, buying options is not a good idea, as you will be buying when prices are about to fall. In this situation, selling premium makes sense. You can construct the iron condor trade using the range estimated via open interest. Or you can sell a short strangle if you are okay with unlimited risk on one side. 

Select your strikes and put them into the option strategy builder before placing the trade. With an option strategy builder, you will be able to input your strikes and expiry date and see the payoff chart, breakevens, and maximum loss before depositing any margin into the trade. One single step will turn speculation into a trade with clearly defined risk boundaries.

Plan the size of your position and exit points

Position sizing and exit rules are equally important. Set your exit points before entering the trade, not after. Taking profits at 50% of maximum loss is better than waiting till the expiry, since the last days carry significant risks relative to the low reward. Breaking through the support or resistance levels identified in the previous stages is a signal to exit early.

Sum It All Up

There is no need to use a dozen different tools for that. The option chain provides you with the locations of big money positions, and IV gives you the expected move. The option strategy builder turns your expectations into a trade with defined risk. Missing any of the stages leaves you with speculation instead of strategy.

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