So You Want to Trade Options: Measuring Sentiment with Options

              

So, you want to trade options, do you? Luckily, you've come to the right place -- here at Schaeffer's, we're all options, all the time. Of course, trading options is easier said than done, particularly if you're brand-new to the exciting world of derivatives. Each week, So You Want to Trade Options is here for you with guidance, definitions, insider tips, and behind-the-scenes information.

In today's thrilling column, we're going to take a long, hard, and hopefully insightful look at options as a sentiment indicator. As you may or may not be aware, sentiment analysis is a key component of Bernie Schaeffer's Expectational Analysis^® methodology (and if you count yourself among the unaware, please avail yourself of this link at your nearest opportunity). However, judging by some of the emails I receive from readers, there's a bit of confusion as to how option activity factors into the sentiment picture. For a comprehensive breakdown of some commonly cited indicators, read on.

The Schaeffer's put/call open interest ratio (SOIR)

This particular indicator is exclusive to Schaeffer's, as the name suggests. Because our primary focus is short-term option trades, the Schaeffer's put/call open interest ratio (SOIR) is tailor-made to our specific sentiment analysis needs. This ratio measures put open interest against call open interest among options set to expire within three months, providing insight into the general mood among speculative investors.

So, readings above 1.0 suggest that puts are more prevalent than calls among near-term options. Conversely, readings below 1.0 indicate that calls are more numerous, while a reading of 1.0 exactly tells us that calls and puts are in parity among the front three months' series.

This raw number can be revealing, but it actually doesn't provide the whole story. Some stocks consistently attract more calls than puts -- perhaps because they have a relatively low per-share price, making put speculation less appealing to potential bears. Or, perhaps we're just talking about a perpetual fan favorite on Wall Street that's generally surrounded by high hopes.

In any event, we put the SOIR in historical context by assigning it an annual percentile rank. A rank of 0% reveals that calls are currently outnumbering puts by the greatest margin seen within the past 52 weeks. Conversely, a 100% ranking tells us that short-term traders are favoring puts over calls more than any other time during the past year.

As an example, take Fannie Mae (FNM) and US Bancorp (USB). FNM currently sports a SOIR of 0.85, with calls outnumbering puts among options set to expire within three months. However, this ratio ranks in the 93rd annual percentile, just seven percentage points from a bearish peak. USB's SOIR stands at 0.88, not too far from FNM's -- but this ratio ranks in the 44th annual percentile, falling on the modestly bullish side of neutral.

Of course, open interest doesn't necessarily tell the whole story, because this indicator doesn't differentiate contracts that were bought to open from those that were sold to open. Many readers have asked me whether the presence of calls and puts that were sold to open can potentially "distort" the SOIR, and my usual response is this: never pull the trigger on a trade on the basis of the SOIR alone -- or, for that matter, on the basis of any single indicator taken out of context.

See, Expectational Analysis is based on the notion that investors should examine a potential trade from several different perspectives in order to get a handle on all of the catalysts that could affect the equity's movement during the foreseeable future. Only by thoroughly sizing up the security's technical, fundamental, and sentiment backdrop can you make an informed decision. And, as long as the SOIR is correctly used in concert with other sentiment indicators, I strongly suspect you won't be led astray.

ISE and CBOE volume ratios

Daily put/call and call/put volume ratios from the International Securities Exchange (ISE) and the Chicago Board Options Exchange (CBOE) are another useful sentiment tool, and they're a logical complement to equity SOIR readings. These ratios measure how many calls and puts were bought to open during the previous session on each respective exchange. Because the data is limited to buy-to-open activity among retail-level investors -- rather than market makers or institutions -- it provides valuable insight into the sentiment surrounding a stock.

Of course, as with any other indicator, these ratios must be taken in context. For example, stock XYZ might be attracting a large amount of buy-to-open call activity, which would appear bullish at first glance. However, if the stock has a massive short-to-float ratio, it's possible that traders are simply buying calls to hedge their short stock positions. In the same vein, a flood of put volume on a strongly uptrending stock could indicate that traders are hedging their long stock positions with short option trades.

But, when used in their proper context, these ratios can be quite telling -- especially ahead of events such as earnings, which tend to draw plenty of attention from the speculative crowd. As an unfortunate caveat, this is proprietary data that we receive from the exchanges, so the average trader can't access this information with the greatest of ease. Fortunately for you, we're generous, options-obsessed people, so we do our best to share this data.

My colleague Nick Perry posts daily "Option Skews" blogs here on our site, where he lists the previous day's most notable call and put activity from the ISE. These charts are easy to scan, so they're a great jumping-off point for your research. Plus, Nick usually highlights a couple of specific stocks that have piqued his interest -- whether because the option activity seems out of line with the price action, or simply to note the news that sparked the day's speculation.

Additionally, my daily Option Activity Alert column zeroes in on some notable securities from our ISE data. While Nick's posts provide a broad overview of the option volume, my column drills down for a closer look at a specific stock's option trends, short interest situation, and technical performance.

Open interest configurations

A final, crucial ingredient to analyzing sentiment with options is the equity's open interest configuration. Basically, you're looking to see where traders have placed their bets. Is there huge out-of-the-money put open interest? This could indicate strong bearish sentiment from speculators. Likewise, a relative scarcity of out-of-the-money calls could point to very low expectations for the stock to rise.

In addition, we seek out major accumulations of near-the-money call or put open interest, because we've found that stocks can get "pinned" to heavily populated strikes as expiration approaches. If there's a possibility that heavy open interest could keep the stock stagnant, it could throw a wrench in an otherwise-solid bullish or bearish prospect.

Similar to the "pin" effect, heavy accumulations of out-of-the-money puts can provide support when options expiration is looming. As market makers gradually unwind the hedges related to this open interest, it can provide a mild tailwind for the security. Alternatively, major overhead call open interest can act as resistance. (To learn more about this interesting phenomenon, check out this link to our Education section.)

Sometimes, however, a stock's open interest configuration can lead us astray. This is especially true now, when the January 2010 series is included in our SOIR calculation. Because these contracts were trading as LEAPS for years, there could be a significant number of calls or puts in open interest that are lingering at deep out-of-the-money strikes. The traders who purchased or sold them might have already given up on the position, and are prepared to let them expire worthless. This is definitely something to look out for when analyzing open interest configurations.

And, as you might expect, we have a handy tool to dodge this potential red herring -- the gamma-weighted SOIR. This indicator places more weight on option strikes that are close to the equity's current price, thereby eliminating any false sentiment signals from way out-of-the-money strikes. But I'm going to refrain from rambling too much about this nifty indicator, because it happens to be the topic of the By the Numbers column that Rocky White and I are planning for tomorrow.

So, those are the key points to keep in mind when studying option activity to measure investor sentiment. There are a few potential pitfalls that could trip up beginners, but a little education and practice should make you an options-analyzing pro in no time.