Understanding PCR in commodity options
The futures value, the underlier for the option, was ₹37886 per 10 gm.
1. What is a call option and a put option contract?
A call option facilitates the purchase of an underlier at a fixed price on a future date, while a put option allows a trader/ hedger to sell an underlier for a fixed price in future. The call and put buyer pay a premium to the option sellers. If the underlying price rises above the level (strike) purchased plus premium paid (to the seller), the call option buyer makes money and if the price falls below the level purchased minus premium paid (to the put seller) the put buyer makes money. It is instructive to note that the call seller feels the price wouldn’t expire above the level sold plus premium received from the call buyer and the put seller believes the underlier wouldn’t expire below the level sold minus the premium received from the put buyer. Whenever, you buy or sell an options or futures contract, you create open interest (OI) as long as you hold it. This is explained in ET’s October 15 edition titled “Understanding Open Interest in Commodities”.
2. What is PCR?
PCR or put call ratio with reference to OI is arrived at by dividing the total put option OI by call option OI. In theory a reading of 1 indicates a perfect market for hedgers but, oftentimes, the OI reading is below or above 1.
If it’s sharply above 1, it indicates an overbought market and if its significantly below 1, it indicates an oversold market. If one considers MCX gold options expiring on November 27, the total put OI intraday Tuesday was 2155 lots (1 lot equals one kilogram) and the total call OI was 2226 lots. Therefore, PCR is around 0.97. Similarly, the individual level or strike PCR can be worked out.
The futures value, the underlier for the option, was ₹37886 per 10 gm. The 37900 strike call and put becomes at the money (ATM) option — price interval between strikes is 100 rupees. The PCR of this strike is put OI of 67 divided by call OI of 11, or 6.09. Such high PCR is largely because the liquidity of gold options, launched a few years ago on MCX, has yet to increase.
3. How does one interpret this data?
While MCX options’ liquidity will increase over time with greater participation, it’s instructive to note that on Comex gold options, from which domestic gold traders take price cues, a PCR of 1.3 and above normally begins to attract selling while that of 0.7 and below begins attracting the bulls or buyers, said commodity traders. Basically, option traders sell more puts than calls when they expect underlying prices to remain steady or to rise. If this happens it enables them to pocket much or all of the premium paid by the put buyers. More of call selling happens when sellers feel that underlying prices will remain steady or fall, which will lead to buyers forfeiting much or all of the premium (paid to the sellers) by expiry.
4. What are the risks involved?
Writing or selling options is highly risky as the seller is exposed to unlimited risk as opposed to the buyer who’s maximum risk is limited to the premium paid to buy a call or put option contract. Therefore, many a time, but not always, the seller tends to be wealthier and better informed than the buyer. She also has to put up substantially higher margin with the clearing corporation to sell options. It’s estimated that 80% of the time the option seller makes money.