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Knowledge Corner

Futures & Options [F&O] – Index Options

Predicting market trends with INDEX OPTIONS
Introduction
In this volatile market it is becoming extremely difficult for day traders and investors to predict the future market movement. Trading in this choppy market is becoming complex day by day and one need to be equipped with new tools and market indicators with which they can predict the market behavior and invest accordingly. Option market have grown by leaps and bound in current market phase. Average turnover in Index option has almost doubled compared to Index futures. Thus it is necessary to study the activity on option in detail. Put – Call Ratio is one of the important market indicators, others being volatility trading, Options Greeks, Options pricing models, etc. which we would covering at a later date.
While most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of their value as predictive tools. PCR volume/open interest is one of the reliable indicators of direction of future market. It is a contrarian sentiment measure. By tracking the daily and weekly volume/open interest of puts and calls in the stock market, we can gauge the feelings of traders. While too many put buyers usually signal that a market bottom is nearing, too many call buyers typically indicates a market is in the process of making its top.
For investors who have difficulty in understanding the hypothesis associated with options market, here's some clear explanation.
How can I use options?
If you anticipate a certain directional movement in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity. The decision as to what type of option to buy is dependent on whether your outlook for the respective security is positive (bullish) or negative (bearish). If your outlook is positive, buying a call option creates the opportunity to share in the upside potential of a stock without having to risk more than a fraction of its market value (premium paid). Conversely, if you anticipate downward movement, buying a put option will enable you to protect against downside risk without limiting profit potential. Purchasing options offer you the ability to position yourself accordingly with your market expectations in a manner such that you can both profit and protect with limited risk.
Why do I invest in Options? What do options offer me?
Besides offering flexibility to the buyer in form of right to buy or sell, the major advantage of options is their versatility. They can be as conservative or as speculative as one's investment strategy dictates.
Some of the benefits of Options are as under:
  • High leverage as by investing small amount of capital (in form of premium), one can take exposure in the underlying asset of much greater value.
  • Pre-known maximum risk for an option buyer.
  • Large profit potential and limited risk for option buyer.
  • One can protect his equity portfolio from a decline in the market by way of buying a protective put wherein one buys puts against an existing stock position.
  • This option position can supply the insurance needed to overcome the uncertainty of the marketplace. Hence, by paying a relatively small premium (compared to the market value of the stock), an investor knows that no matter how far the stock drops, it can be sold at the strike price of the Put any time until the Put expires.
  • E.g. An investor holding 1 share of Infosys at a market price of Rs 1600/-thinks that the stock is over-valued and decides to buy a Put option' at a strike price of Rs. 1600/- by paying a premium of Rs 200/-
  • If the market price of Infosys comes down to Rs 1400/-, he can still sell it at Rs 1600/- by exercising his put option. Thus, by paying premium of Rs 200, his position is insured in the underlying stock.
What are the uses of Index Options?
  • Index options enable investors to gain exposure to a broad market, with one trading decision and frequently with one transaction.
  • To obtain the same level of diversification using individual stocks or individual equity options, numerous decisions and trades would be necessary.
  • As a percentage of the underlying value, premiums of index options are usually lower than those of equity options as equity options are more volatile than the Index.
How to predict market trends with Index Options
Generally option traders are tracking the P/C ratios of Nifty futures, to predict the market trends. P/C ratios gives us a general trend of the markets , If the P/C ratios is more than 1.2 means, majority of the market participants are holding long positions of Puts so one should buy Calls. On the other hand, if the P/C ratio is below 0.2 means majority of the traders are long in Call so we should buy Puts. It actually suggests market participants’ view; a knowledgeable derivative trader should take the opposite position after assessing the P/C ratios. P/C ratios can be calculated by using the total volume or by open interest of all existing calls and puts of Nifty (underlying).
Apart from the P/c ratio a common man can also make use of open interest of Nifty put and calls for the predicting the future outlook of the market. At any point of time, if someone wants to predict the market outlook, he has to check open interest of various strike price of both call and put options and compare with the previous respective open interest. The typical increase and decrease in open interest in the Nifty put options are also can be considered for predicting the market trends. If the open interest of put options in various strikes are on decreasing mode sends an early message of reversal in the market trend, and expect a bull run on Nifty futures. On the other hand if the open interests of put options are increasing, all of a sudden then expect a bear rally. Increase and decrease of open interest in deep-in-the-money call and put options are also indicating the strength and weakness of bear/bull rallies. Because the deep-in-the-money option buyers are paying high premiums for buying both call and puts. In a bull market one can see huge build-up in deep-in-the-money call options. Same way if market participants are expecting a major correction then we can see huge build up in the deep-in-the-money put options.
The basis of open interest analysis depends on the assumption that the option buyers are vulnerable to time decay of options and hence they have to exit and enter frequently according to the market conditions in order to protect the time decay.
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