SL Green Realty Corp. and the Gamma-Weighted SOIR, By the Numbers

              

We're going to be open and honest about this right up front: we don't have particularly strong feelings about SL Green Realty Corp. (SLG: sentiment, chart, options) one way or the other. However, the stock is helping us make a point today about a rather prickly aspect of short-term sentiment analysis; specifically, the presence of deep out-of-the-money open interest, and its ability to skew certain sentiment analysis tools. If you haven't yet learned the benefits of using the gamma-weighted SOIR, you definitely need to keep reading.

The trouble with LEAPS

Now, we don't have a problem with LEAPS (Long-term Equity AnticiPation Securities) per se. However, one of our favorite ways of measuring sentiment among short-term option traders is by checking out the stock's Schaeffer's put/call open interest ratio (SOIR). Toward the end of the year, the January series from the next calendar year gets rolled into the SOIR calculation, because it measures the front three months' worth of open interest. And this is where LEAPS can cause us some headaches...

Because LEAPS are optionable several years out, it's possible that some of the options in the January 2010 series were purchased back in, say, early 2008. Unless you've been living in a makeshift bomb shelter, you've probably noticed that the majority of U.S. equities have experienced major, and occasionally stomach-churning, price changes during this time frame. As a result, there's a good chance that much of this LEAPS open interest is either deep in the money, or deep out of the money.

In other words, it would be a misstep on our part to read too much into any given stock's open interest configuration for January, or any other LEAPS series. Yes, there might be a massive accumulation of deep out-of-the-money call open interest at overhead strikes -- but it's possible that these calls were purchased two years earlier, when the shares were trading higher on the charts. Now that the stock is trading lower, it's likely that the speculator who purchased these calls has resigned herself to letting them expire worthless. Not much of a compelling sentiment read, is it?

If you're following us this far, you've probably determined by now that the SOIR can also be influenced by these "dead weight" open interest accumulations. So, whenever a new January series is rolled into the calculation, we're very cautious about interpreting the open interest data. A very low SOIR reading might mean that traders were bullish on the stock 14 months ago, even if they're not now. Of course, even when there aren't any LEAPS involved, this ratio can still be influenced by aberrant accumulations of far-out open interest, making this a potential year-round pitfall.

Because we like to make things easy on ourselves, our Research team at Schaeffer's developed a more finely honed tool to eliminate any false sentiment signals that could result from way out-of-the-money open interest: the gamma-weighted SOIR. Gamma is one of the so-called "Greeks," and it measures how much an option's delta will change with respect to a change in the underlying equity's price.

An at-the-money option will have a very high gamma, but the further away the strike price is from the price of the stock, the smaller the gamma will be. To calculate the gamma-weighted SOIR, we multiply the option's gamma by its put open interest, and then we multiply it by the option's call open interest. Dividing the gamma-weighted puts by the gamma-weighted calls gives us the gamma-weighted SOIR. The indicator gives higher importance to open interest that is near the money, and almost disregards open interest that is either deep in the money or deep out of the money. Therefore, it's an ideal tool to filter out ancient, out-of-the-money open interest.

Sizing up the stats for SL Green

All of which brings us back to our example stock, SLG. Now, SLG doesn't even trade January 2010-dated options, but the gamma-weighted SOIR is nevertheless going to reveal some very interesting facts about the stock's open interest configuration -- proving that you don't have to wait until the end of the year to use this nifty tool.

The equity's SOIR checks in today at 2.35, revealing a preponderance of puts among options set to expire within three months. This ratio ranks in the 74th annual percentile, indicating that puts have been more popular among short-term speculators only 26% of the time during the past 52 weeks.

However, the equity's gamma-weighted SOIR reveals an even more drastic skew toward puts, with this indicator checking in at 4.29. In other words, puts more than quadruple calls among near-the-money options set to expire within three months. This reading is markedly more bearish than SLG's traditional SOIR, revealing a strong bias toward pessimistic at-the-money positions. And, as you can see from the chart below, the SOIR and gamma-weighted SOIR were more or less keeping pace with each other until October expiration.

What's the cause of this major difference in the two SOIRs? The stock's November 35 put carries a whopping 11,766 contracts in open interest, while the most heavily populated near-the-money call is the November 45 strike, with just 3,179 contracts outstanding. Beyond that, the second most popular near-term call is the November 55 strike, with 2,730 open positions.

So, with SLG trading just shy of $40, it's safe to say that traders are definitely favoring puts over calls among near-the-money strikes. In SLG's case, the presence of a relatively minor amount of out-of-the-money call open interest is diluting the impact of massive, near-the-money put open interest. Whether you're dealing with LEAPS, or just looking to refine your sentiment analysis, the gamma-weighted SOIR can be quite revealing.

If you'd like to check out this handy sentiment indicator to add another tool to your trading arsenal, simply follow this handy link to our Quotes & Tools page. And, as always, please contact us with any questions, comments, or suggestions for future columns.