Many a time it is witnessed that several trades in the live market do not see the right anticipation of short covering or long unwinding and, therefore, miss an opportunity or get into unprofitable trades. All the more it becomes challenging, because Nifty and Bank Nifty are two dynamic markets where traditional indicators mislead, in congestion levels.
With such difficulties, the importance of option data analysis has kept increasing. Open interest shall tell the trader the market sentiment and probable movements provided it is really understood and interpreted.
In this article, we provide you with a step by step process of identifying events such as short covering and long unwinding using options data. Using this technique, the trader can enhance his decision-making, ultimately improving the trading outcome.
Understanding Short Covering and Long Unwinding
Let’s define what short covering and long unwinding mean, to be sure of our understanding before getting into the details of the steps.
Short Covering
This is when the security that was earlier sold by traders (shorting) is bought back into their position. This buying pressure can drive the prices higher sharply.
Long Unwinding
The sale of a security by the traders who are long in it. The security is sold either to be used for some other purpose or to get rid of the security in the portfolio. Selling creates pressure, which sometimes results in a fall in the price.
The Importance of Open Interest
Open interest represents the total outstanding contracts not yet settled in both calls and puts. It is, therefore, an important indicator as it provides a feel of the market dynamics and points out if there is a potential short covering or long unwinding.
Identify from Where Short Covering and Long Unwinding is Taking Place
Step 1: The Charts Setup
So, first, you are going to need a rudimentary charting platform that most brokers provide—the likes of TradingView or ChartIQ would be great, as these enable multiple charts to appear on one screen simultaneously.
- Chart setup: 3-minute charts of the underlying (e.g. Nifty 50) and the option of the underlying (e.g. Nifty 50 15900 PE).
- Chart settings: Your charts should be set to show the Open Interest (OI) with the price.
Step 2: Track Price and OI Movements
With the charts in place, a person can actually witness how the security’s price changes are taking place along with such changes in interest.
- Rising Prices with Rising OI: This ensures that fresh short positions have been initiated. If the option price rises and the OI moves up, such a situation would point out that the number of traders writing options is increasing, thus creating new shorts.
- Decrease in OI but the increase in prices: Indication of short covering When the price of the option rises alternately with the decrease in OI, it indicates the covering of short sellers buying back their wagers corresponding to the decrease in the selling bet data moving their prices higher during this process.
Step 3: Real Time Data Processing
Here, one has to factor in real-time data for live trading sessions. However, most of the retail traders can access data, updates for every 3 minutes contrary to the tick-by-tick data accessible for High-Frequency traders.
- 3 Minute Data Analysis: Check OI data every 3 minutes. And in case if you notice there is a huge fall of OI with price going up then this you can be sure is short covering.
- Pattern spotting: Look out for patterns where the price stabilizes and surges after some time. This, if with a falling OI, confirms short covering.
Case Study: Nifty 50 on 26th May
Nifty 50 15900 PE
The market at 15900 was trading between 10:30 AM-12:00 PM. The price of this 15900 put option slightly moved from Rs 15 to Rs 50, and OI has increased in this time as well, which reflects that some fresh put writing was observed as traders were expecting market stabilization.
Market Reversal
After 12:00, the selling in the market finally got lapped up, and the market started taking an upside turn. As the price of the Put option started moving downside so did OI, inferring long unwinding by the Put writers, or in other words short covering.
Confirmation
That the major reduction in OI with an increase in the price of the underlying is a confirmation that the up-move in the market was propelled by short covering.
Practical Tips for Traders
- Multiple Time Frames: Multiple time frames should be considered, 1- and 3-minute charts function well and make it easier to understand OI changes.
- Broker Efficiency: Ensure that your broker is updating both data efficiently and, most importantly, in time. In most cases, delayed data leads to the loss of trading opportunities.
- Pattern consistency: Regularly practice identifying the patterns in OI and price movements to build confidence and accuracy in trading decisions.
Conclusion
The skill of identifying short covering and long unwinding with the help of options data is something very few traders master. A trader targeting relevant open interest and price movements draws interpretation indications on overall market dynamics, giving room for applied, very informed market judgments. The more you practice and fine-tune this technique, the more it’s going to become second nature and an integral part of your trading strategy.
If you’d like to reach still further with the development of your intraday trading skills, then I would suggest going further and accessing additional resources, such as audiobooks or in-depth guides on trading psychology and technical analysis.