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Reading the Alt Crowd: Gauging Stock Momentum with Options

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April 28, 2015
gauging stock momentum with options analysis
Frederik Broden

Load up the Trade Page on TD Ameritrade’s thinkorswim® platform and you’ll find a dizzying array of flashing numbers. To the veteran options trader, that particular light show makes sense. But if you’re an investor who doesn’t usually trade options other than to sell the occasional covered call, you might ask, what’s the point? Certain interesting options metrics can be instructive, regardless of your trading habits. I’m not referring to the greeks like delta or theta—those are by nature theoretical. I’m referring to those derived from options-trading activity—the collective buying and selling of the options themselves. The idea being that you can get a sense of what a stock might do based on what traders are doing with its options. The three more useful metrics are:

1. Open interest
2. Put/call ratio
3. Sizzle Index®

Think of these as “options-market internals.” They often deliver market clues on sentiment, and indicate where money may be flowing. 

Open Interest: One Critical Indicator

Open interest is best defined by how it’s calculated. When an exchange creates a new options series, before trading begins, the open interest is zero. Every trade is either opening, where a trader establishes a new position, or closing, where a trader exits an existing position. So, a buy might be opening or closing, and a sell might be opening or closing. That said, an option’s first buy and sell are both opening trades. For every option position created through an opening trade, open interest goes up by one. For every position closed, open interest goes down by one. So open interest is the number of options in traders’ positions not yet closed—either long or short. 

options open interest analysis

FIGURE 1: OPEN INTEREST

Based on the theory of “max pain,” options’ open interest can show you where potential support and resistance. They’re where the traders are screaming “uncle” and get in, or bail out. For illustrative purposes only.

Referring to Figure 1 above, you can find an option’s open interest on the Trade tab of thinkorswim.

1. Enter a symbol in symbol box.

2. Select “Layout: Volume, Open Interest” in the right drop down of the “Option Chain” section.

3. Open interest now appears in the option chain columns for both calls and puts.

Some look at an option’s strike price with the highest open interest and interpret that as either a potential stock-price target, or maybe even support (for strike prices below the existing stock price) or resistance (strike prices higher than the current stock price).

According to the theory of “max pain,” investors typically buy calls and puts, either as directional bets on a stock or as a hedge. If the stock price is away from the strike price, either the calls or puts at that strike will be in the money, and the trader who bought the call or put that is now in the money could be making money. That’s a good thing. Yet, if the call is in the money, the put at that strike is out of the money, and vice versa. Whoever bought that out-of-the-money option could be losing money. Not good.

But when the stock is exactly at the strike price at expiration, both the calls and puts at that strike are nearly worthless. And whoever bought either call or put could be losing money. That’s the “pain.” The “max” part comes from the strike price that has the highest open interest, where the largest open long-option positions are. If the stock goes to that strike, it could cause the greatest losses for the traders who are long those options.

Is the max-pain theory valid? Hard to say. It can seem like some stocks stay in a range of prices where the strikes have the highest open interest. But that’s not always the case. So you may not want to base your stock price targets solely on the strikes with the highest open interest. Always use more than one indicator. Open interest could be supporting evidence for a next move, along with other technical or fundamental indicators.

P/C Ratio: Not All Metrics are Created Equal

Our second metric is the put/call ratio. This is a straightforward measure of good old market sentiment. It’s simply the ratio of the trading volume in a stock’s puts and calls. If 100 puts have traded, and 100 calls have traded, the put/call ratio is 1.00. If 200 puts have traded and 100 calls have traded, the put/call ratio is 2.00. The p/c ratio is a contrarian metric. Some think it’s a signal for a stock reversal, as most retail-options buyers lose money. That’s debatable, but for the moment let’s go with it.

Say calls are bought after the stock has gone up a lot, and puts are bought after the stock has dropped. Certain investors get caught up in the excitement of a big move up or down and expect it to continue. They place bearish long-put trades after the stock drops, and bullish long-call trades after a rally. That’s the idea, anyway. The p/c ratio is a measure of this kind of activity.

When the p/c ratio is low, more people are trading calls, which can mean retail investors are buying. That can signal a top in the price of the stock, with veteran traders taking profits as retail traders buy, which can lead to lower stock prices.

When the p/c ratio is high, it means more people are trading puts, which can mean retail investors are buying them as a hedge or speculation that the stock will continue to drop. The high p/c ratio can also suggests a stock bottom could be in place, when more experienced traders who have shorted the stock are taking profits by buying their stocks back at lower prices. The pro traders are buying short stock back from less experienced traders who might be exiting their long stock positions, either being stopped out, or having to close positions to meet margin calls. This activity may drive stock prices higher. That’s why low p/c ratios are seen as potential reversals after a stock rally, while high p/c ratios are seen as potential reversals after a stock drop. 

today's options statistics and sizzle index thinkorswim

FIGURE 2: MORE VOLATILITY DATA, PLEASE

"Today's Options Statistics" in the thinkorswim Trade Page is where you’ll find the p/c ratio (bottom of yellow box, right) or the Sizzle Index (top of yellow box). For illustrative purposes only.

The p/c ratio, as it’s called is found on the Trade page in thinkorswim. (See Figure 2) Look in the “Today’s Options Statistics” section, and you’ll see “P/C Ratio” on the far right- hand side. A p/c ratio above 1.00 means more puts than calls have been traded. A p/c ratio below 1.00 means more calls than puts have been traded.

So, how can you interpret the data? Is the p/c ratio an accurate metric to predict market reversals? It assumes that buying into strength or selling into weakness leads to losses, and because that’s not true for all investors in all stocks every time they rally or drop, the ratio should be used cautiously in conjunction with other directional indicators. But an extreme level of the p/c ratio can reinforce a bullish or bearish bias, and can assist with timing a trade entry or exit.

For example, an investor who is long stock might look to take profits when the p/c ratio is high after the stock has rallied. Also, what counts as a high or low p/c ratio can be different for different products. For example, the p/c ratio for an index like the SPX or NDX is usually above 1.00 because a lot of institutions regularly buy puts as hedges for their portfolios. Stocks that have a lot of price swings might have p/c ratios between 1.2 and 0.80 as trading activity shifts from calls to puts and back. Before you use p/c ratios to shape your trading decisions, get familiar with their levels for the stock or index you’re trading. One size put/call ratio doesn’t fit all.

Sizzle Index: It’s all Relative  

The third metric—the sizzle index—is a number you’ll find only on the thinkorswim platform. It may as well be called “Relative Options Volume” because in effect it’s the ratio between total-option volume on a given day to the average total-daily option volume for the previous five trading days. It measures whether options trading has been more or less active relative to several days prior. If the sizzle index is greater than 1.00, option volume is greater than the average of the previous five days. If it’s lower than 1.00, the present day’s volume is lower.

You can find the Sizzle Index on the Trade page in thinkorswim (see Figure 2). In the “Today’s Options Statistics” section, you’ll see several Sizzle Indexes:

Sizzle Index on the far-right-hand side

Call Sizzle and Put Sizzle, which measure present-day call or put volume against the previous five-day average

Stock Sizzle, which measures present- day stock volume against the previous five-day average

Volatility Sizzle, which measures present- day vol index against the previous five-day average.

The Sizzle Index can be used in a couple of ways. As a simple indicator, it can show which stocks’ options are generating the most interest, which can signal upcoming news or a corporate event. To a stock investor, a high Sizzle means you should at least be aware of a stock’s potential price swing. The second is if a high or low Sizzle Index coincides with a big swing in a stock price. A big move accompanied by a high Sizzle could indicate continued strength in that move, just as high stock volume might. A big move accompanied by a low Sizzle could indicate the market sees less likelihood of the move continuing.

If you’re painting a mental picture of a stock’s trend, think of its chart as momentum, while its options data fills in the sentiment of that momentum. If you’re charting momentum without sentiment, you could be ignoring critical information that might give you just the push you need to get in or out of a trade.

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