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CM Strategy

Optionalysis: Using the Put/Call Ratio on Stocks Near Expiry For Option Trades (Part 1)

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We saw an interesting discussion on our Slack room: the Put-Call ratio could be a useful indicator to making option trades close to expiry day. The idea is:

• If the PCR based on open interest (Put open interest / Call open interest) of a liquid strike price is greater than 1, it’s bullish. There are more puts in the system than calls, and typically that means the writers of put options (writers are typically stronger hands) will be in control and the system will “resist” going below that strike.

• If the PCR – OI is <1 then that strike is “bearish”. There are many more calls than puts in the system so boom, that above logic says there are more call writers than put writers, and call writers will make it resist on the upside.

In general the put call ratio should be:

• >1 for strikes below the current price.

• <1 for strikes above the current price.

Take an Example

With expiry tomorrow, this holds good for many stocks. ITC, for instance, has results tomorrow. And it’s at 304, with results expected to be lousy. But here’s the PCR situation:

ITC

The green part is bullish, where the PCR is >1. The orange portion is bearish.

With the PCR at 300 at 7.5, and nearly 630,000 shares of OI in 300 strike price puts, there will be a lot of pressure to keep the stock above Rs. 300.

And then there’s about 150,000 call options at 305, where PCR is 0.58.

In effect, since Thursday is expiry day, the PCR is telling us that ITC is expected to be between 300 and 305.

Is There A Trade?

A simplistic trade is to use this logic to go “short” options. For instance, the ITC trade can be:

• short the 300 put option at Rs. 2.05

• short the 305 call option at Rs. 2.75

The trade nets Rs. 4.8 in premium, and protects you for a range of 295.2 to 309.8, for a single day (Thursday, since the contracts mature on Thursday).

The lot size for ITC is 1000 shares, so you make Rs. 4800 premium (max) if stock is between 300 and 305. For a margin of Rs. 65,000 that’s a phenomenal return of around 7.5% in a single day! Of course there is unlimited risk if the stock falls or rises big time.

Note: this is dangerous to do on a day the stock announces results, since it can move like crazy. But danger is what attracts the option player.

A more complex trade is to short both but to “cover” the outer edges. So beyond the above you would:

• Also go long the 295 put at Rs. 1

• go long the 310 call at Rs. 1

This means you receive the above Rs. 4.8 but pay out Rs. 2 for the long options, for a net credit of Rs. 2.8. This again means that for 1,000 ITC shares, your profit is Rs. 2800 for a margin of Rs. 56,000 or so, which is a 5% return.

The max risk here is Rs. 2,200 as a loss, which is also 4%, so there’s that to worry about.

Trading the abnormals

Yesterday @ap_pune noted a trade on HPCL which was posted by Blesson: That HPCL was trading near 940 (in fact, above it) when the PCR at 940 was substantially lower than 1. And intraday, the HPCL stock fell like a rock:

HPCL

The HPCL situation, one day prior (Tuesday’s close) was like this:

• 940 PE was at 4500 shares OI, and 940 CE at 232,500 shares.

• That gives you a PCR of 0.19, while the stock had closed around the 932 levels.

• Even the 920 PE was at a PCR of 0.79 which is low considering the stock was beyond 930.

This is abnormal, and a trade can be: Short the 940 call, or buy a 940 put.

Abhijit (@ap_pune) tracked the position and it looks like both positions did really well. The 940 call fell from Rs. 9.9 to Rs. 2. The 940 put went from Rs. 8 to Rs. 16 or so. This is a ludicrous return. The put went up 2x, and the return on the call (lot size 500, About Rs. 50,000 margin per call) would be a high 7% or so for a day.

At a point so close to expiry, it appears that writing options could be better (you get the time decay very very fast).

Note: You have to be confident about liquidity. For example the HPCL 940 Put had only 4500 shares in OI, that’s less than Rs. 1 crore in exposure! That is usually too little – but in this case it was confirmed by the 920 PCR being low as well. We would suggest that this be paper traded for a few weeks before real money is placed on it. 

Note 2: HPCL has changed. Yesterday at close the 920 PCR had moved up to 1.6, providing a bigger support level. The PCR at 940 was 0.08. So it’s become more “normal”.

Coming up in part 2…

We’ve seen this happen yesterday. What happens today, on expiry day? We have many companies announcing results (ITC, Strides, NTPC) and others with “abnormal” PCRs. We’ll post notes on the slack group with PCRs and more data (mail us if you’re a member and you don’t know what this is) through the day. And we’ll do a post-mortem in a day or so.

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Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion. 

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

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