Learn With ETMarkets: Options demystified 401 – Market sentiment

After discussing option pricing, the Greeks, and how traders utilize these concepts in their trading strategies, Maya proceeded to introduce Tara to the concept of market sentiment derived from options.

Link to previous article: Learn With ETMarkets: Options Demystified 303 - Options Greeks (Part 3) -https://ecoti.in/HGiKuY58

Put-Call Ratio (PCR):
She started by explaining the Put-Call Ratio (PCR), saying, " The PCR is a commonly used indicator to assess market sentiment and predict potential reversals or trends. Traders calculate the PCR using either volume or open interest data."

PCR = Put Volume (or OI)/ Call volume (or OI)

Maya continued, "If we look at the volume-based PCR, we divide the total volume of put options traded by the total volume of call options traded in a given period. It gives us insights into how market participants are feeling and acting in the short term."

"Alternatively," Maya said, "we have the open interest-based PCR. It divides the total open interest (number of outstanding contracts) of put options by the total open interest of call options. This one gives us a glimpse of the longer-term sentiment, as open positions can last for days, weeks, or even months. Sometimes, high open interest in put or call options indicates significant support or resistance levels for the underlying asset."

Tara was intrigued and asked, 'So, which one is better?'
Maya replied, 'The volume-based PCR provides a snapshot of recent trading activity, making it perfect for short-term analysis and identifying immediate shifts in market sentiment. However, we need to be cautious as sometimes big institutional strategies can distort the PCR due to high options volume. On the other hand, the open interest-based PCR gives insights into longer-term sentiment as it considers open positions that can last for days, weeks, or even months. Unusually high open interest in put or call options can indicate significant support or resistance levels for the underlying asset. So, both approaches can be used together.”

Tara exclaimed, 'Ah, got it! We can refer to the volume-based PCR for short-term trading cues and use the open interest-based PCR for longer-term insights.'

Maya nodded and said, 'Exactly! Now, let's delve deeper into the PCR ratio itself. A ratio greater than 1 suggests a bearish sentiment in the market, indicating more trading volume or open interest for puts compared to calls. Conversely, a ratio below 1 implies a bullish sentiment, meaning more trading volume or open interest for calls than puts.”

Tara was intrigued and asked, "I understand the sentiment based on which options are being traded more, but how do traders use the PCR ratio?"
Maya responded, "Traders often see the PCR as a contrarian indicator. For example, when the ratio is extremely high, it means there's a lot of bearishness in the market. Some traders might view it as an opportunity to buy because they believe sentiment has become overly negative. On the flip side, an extremely low ratio suggests excessive bullishness, indicating a possible correction or sell-off."

Tara nodded and asked, "Are there specific levels traders look for in the PCR?"
Maya explained, "There's no universal threshold. Traders consider historical data, market conditions, and their own strategies. They might compare the ratio to historical averages or look for extreme readings that deviate significantly from the norm."


Tara thanked Maya for the insightful explanation and asked, 'What other tools do traders use to gauge market sentiment?'

Option Chain:
Maya smiled and said, 'Great question! Another important tool is the Option Chain. It's like a treasure trove of information, providing a comprehensive listing of available options contracts for an underlying asset. By examining the option chain, we can focus on a few key aspects to understand market sentiment.'

Excited to learn more, Tara said, 'Tell me about it!'


Maya continued “We can look for the following aspects in the option chain

a) Examine the open interest:
Look for the open interest column in the option chain. Open interest represents the total number of outstanding contracts. Higher open interest indicates greater interest and potential market sentiment. Focus on the strikes that have a significant open interest. It indicates potential bias around that price level.

b) Analyze the volume:
Consider the volume column in the option chain, which represents the number of contracts traded during a specific period. Higher volume at a particular strike indicates increased activity and potential market sentiment.

c) Evaluate the bid-ask spread:
The bid-ask spread is the difference between the bid price (price at which traders are willing to buy) and the ask price (price at which traders are willing to sell) for an option contract. A narrow bid-ask spread implies high liquidity suggesting that traders are actively trading that option contract, indicating potential market sentiment and bias towards that level.

d) Consider implied volatility:
Implied volatility (IV) is a measure of the market's expectations for future price volatility of the underlying asset. By examining the implied volatility of options at different strikes, you can gain insights into market sentiment. For instance, if you find that the IV is significantly higher for out-of-the-money (OTM) put options compared to OTM call options, it suggests a bearish bias or sentiment among market participants.”

Tara connected the dots and said, "So, the Option Chain analysis gives us important price levels that act as support or resistance. Is there any specific level that's most important?"

Maya smiled and said, "The levels keep changing based on trading, but there's a relatively new concept called the max pain theory. Have you heard of it?"

Curious, Tara admitted, 'No, I haven't. What's the max pain theory?'

Max Pain:
Maya explained, "The max pain theory suggests that the price of the underlying asset tends to settle near the option strike price where the maximum number of options contract holders experience the least financial gain or 'pain.' It is more of a theoretical concept and not a precise science and is based on the assumption that option writers, who have more risk than reward, take actions to keep the price of the underlying asset close to the strike prices of the options they've written. By doing so, they can reduce the likelihood of paying out significant profits to option holders. There's an adage that says it's the option writers, not the option buyers, who make consistent money."

Intrigued, Tara asked, "How does the max pain level is calculated?"

Maya elaborated, “The calculation of max pain involves determining the price level at which option writers experience the least financial gain or ‘pain’. To calculate max pain, you would analyze the open interest data for both call options and put options on a particular underlying asset. The objective is to identify the strike price where the total value of outstanding options contracts is the lowest, thus causing the least financial gain for option holders.”

Understanding the concept, Tara wondered, "Does the max pain theory have practical implications for options traders?"

Maya nodded and said, "Absolutely. Some traders who believe in the max pain theory use it as a factor when making trading decisions. They analyze the open interest and volume at different strike prices to identify potential levels where the price of the underlying asset might gravitate. This information helps them choose their trading strategies."

Tara exclaimed, "That's interesting! I'll explore these things further. Thanks for explaining, Maya!"

Maya responded, "You're welcome, Tara! It's always exciting to explore different theories and strategies in options trading. Just remember, these sentiment indicators are just a few tools among many. Traders combine it with other technical and fundamental analyses for a more comprehensive understanding of the market."

(The author is CEO Yubha.com, TradingHeads.com)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)