10 must know terms for derivatives trading analysis

Basics of  Derivatives Trading

There are some terminologies and keywords that are must know for any future and options trading beginners. Without understanding of these terms it will not just be difficult to trade in future and options but in order to interpret the analysis from derivatives data one should have clear understanding of these basics.  

Strike Price

Future and Options are contract between two parties that agree to buy/sell the underlying asset on pre-agreed date (Expiry) and at agreed price. This agreed price of the contract is called the Strike Price of the contract. Strike price is also know as exercise price of the option contract. For call options, the strike price is where the security can be bought by the option holder; for put options, the strike price is the price at which the security can be sold.

Put Option

Put option gives the buyer right but not the obligation to sell the security at the strike price before the expiry. The buyer of the put option expects the security price to fall below the strike price. By exercising this option the buyer expects to make profit from the difference between the strike price and market price of the security. 

For example, let us assume that ICICIBANK was trading around 400 and you expect that the price will correct. So you buy a put option at strike price of 380. When the price go below 380 say up to 350 you will exercise your option to sell your holding at 380. It will be like you will buy at 350 and sell at 380 and keep the profit of 380-350 with you.

Call Option

In contrast to put options, Call options give the buyer the right to buy the security at the strike price before the expiry. The owner of the call option will exercise his option, to make profit, if the security price will go above the strike price of the option contract. If the security price stays below the strike price at the end of the expiry, the option will die worthless and the option owner will loose the premium paid.

For example, let us assume that ICICIBANK was trading around 350 and you expect that the price will go higher. So you buy a call option at strike price of 370. When the price go above 370 say up to 400 you will exercise your option to buy ICICIBANK for 370. It will be like you will buy at 370 and sell at 400 and keep the profit of 400-370 with you.

Open Interest (OI)

Open Interest in derivatives trading signifies the total number of active contracts in the market that have not been settled for an asset. Unlike stock trading where there is a fixed number of shares in circulation, the total number of contracts in the Future and Options varies. As new seller/buyer get into agreement, the Open Interest for a security derivatives changes on daily basis.

If a buyer and seller come together and initiate a new position of one contract, then open interest will increase by one contract. Should a buyer and seller both exit a one contract position on a trade, then open interest decreases by one contract. However, if a buyer or seller passes off their current position to a new buyer or seller, then open interest remains unchanged.

Premium

Option contracts give the buyer right but not the obligation to exercise the option (buy or sell the security). In order to compensate the option seller/writer for such contract, the buyer pays a small fees called Premium. Since the option buyer will exercise the call or put option only if it is profitable, the premium amount is the cost paid to option writer for such contract.

As the premium is the cost to buy any option, the buyer should always consider this amount to estimate the profit/loss in the trade. In the above example, if to buy Call or Put option of ICICIBANK one had to pay a premium of 10, then the profit would be 30-10. 

Implied Volatility (Vega)

Volatility signifies the fluctuation in the price of the security. If the price of stock swings heavily in both directions, in a short period of time, then the stock is said to be highly volatile. Implied Volatility (IV) indicates the market's view on the change in price of the security.

For options contract, implied volatility is one of the factors driving the price paid to buy the option (Premium or LTP). As the implied volatility increases, the premium value increases and vice-versa. This is because if the stock price is expected give big movements, it is more likely that price will cross-over the Strike Price giving profits to the option buyer. Therefore, the option writer/seller wants bigger compensation/premium  for his risk.

While buying an option, the trader should consider the implied volatility of the security and the premium associated with it. For example, in view of events like election results, financial results etc the premium cost will be much higher as the IV is also high thus giving little room for option buyer to make profit. 

Long Position

Long position signifies bullish sentiments. It means that the holder owns the stocks with the expectations of price going further up. With options, buying a call or put is a long position; the investor owns the right to buy or sell to the writing investor at a certain price.

Long unwinding is done when the trader realizes that the price is moving against the expectations and they start dumping the long positions.

Short Buildup

In contrast to long position, Short Buildup signifies bearish outlook. The trader owes the stock to someone but does not actually own the stocks currently. If you expect the price to go further down from current market price, you will short your positions that is get in agreement with the buyer to sell the stock at price X. When the stock price goes further down you will buy at price Y, and in turn make a profit of X-Y. Selling or writing a call or put option is a short position; the writer must sell to or buy from the long position holder or buyer of the option.

When the trader realizes that price will not go further down and it will go against his bets, he will start unloading the short positions.

Support 

In technical or derivative analysis, Support is the price range of the stock from where the downtrend in the price may reverse or receive hurdles. It signifies that there are buyers that are willing to buy the stock around that price.

There are different ways to estimate the support level for the stock price. One can look at the different chart trends or analyze the future and options data to estimate the support level. 

For example, from the options chain we can understand the strike prices at which there are maximum put writing. Since put writers are majorly the big players of the market ,with more resources like analysts and finances, and option writers are usually the ones making money from the contracts, one can assume that strikes prices at which these player write put contracts, they will not allow the price to move below them as they will tend to loose money.

Resistance

Resistance is the price range of the stock from where the uptrend in the price may reverse or receive hurdles. It signifies that there are sellers that are putting selling pressure on the stock around that price.

From the options chain we can understand the strike prices at which there are maximum call writing. One can assume that strikes prices at which there are heavy call writing, the call writers will not allow the price to move above them as they will tend to loose money. Such strike prices can provide some resistance to upward trend in the stock price.

StoxFactor dashboard provides ready to use insights on support and resistance level for stocks and indexes from both derivatives data and charts.

The above chart for ITC shows the strike prices at which there are maximum number of open interests for Call and Put options.

Moreover, from the candle stick chart we observed that in the month of August 2020 (refer August month data in put-call chart above) the price moved majorly in the price range 190-200.

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