by Randy Frederick 09/30/08
This is the second article in the series, be sure to read How to Track Options Volatility - Part I.
Let's examine the difference between option trade volume and open interest ratios, and what each one is measuring, to see how it might or might not be helpful.
Short-term traders often watch the intraday volume of puts compared to the intraday volume of calls. During the day, the Chicago Board Options Exchange (CBOE) posts an aggregate volume for the contracts it trades, and the put/call ratio based on that volume is posted to its website about every 30 minutes.
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Drawbacks to Using Put/Call Ratios
While this may be somewhat helpful, there are some drawbacks that can make this ratio potentially misleading. First, this volume is for contracts traded on the Chicago Board Options Exchange (CBOE) only, and it's only updated about 12 times a day. Most options are now listed on multiple exchanges, and the International Securities Exchange (ISE) actually does more equity option volume now than the CBOE does. Volume could be significantly lighter or heavier on another exchange.
Another drawback to put/call ratios is that, even though we can access individual exchange volume data during the day, there's still no way to know what portion of the volume was closing customer transactions and what portion was opening customer transactions.
As a result, it's impossible to know whether the trades you see will result in an increase or decrease in the open interest calculation. This is the main reason why daily volume put/call ratios are of somewhat limited value.
To understand why this can be misleading, consider this example: If open interest yesterday on a particular option was 1,000 contracts on the calls and 1,000 contracts on the puts, the open interest put/call ratio would be 1.00. Assume today's volume is 400 contracts on the puts and only 100 contracts on the calls. The daily volume put/call ratio would be 4.00.
While four puts trading for every one call contract may seem to reflect very bearish sentiment, it could be exactly the opposite of that. You can't simply assume that all 400 put contracts were opening positions. If all 400 put contracts were closing trades and all 100 call contracts were opening trades, then tomorrow's open interest would be 600 on the puts and 1,100 on the calls, for an open interest put/call ratio of .54.
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This might indicate that today's traders were bullish, not bearish. If you are going to watch daily volume put/call ratios, you may want to consider viewing a 21-day average volume, which combines trades from all exchanges. You can then look for trend changes rather than simply looking at a single-day spike on a single exchange and assuming that a major sentiment shift has taken place.
The third drawback to viewing daily volume ratios is that, while the CBOE calculates the ratios based on equity volume and index volume individually, much of the equity option volume is retail trading, while institutional traders tend to comprise the bulk of the index option volume.
Sam Collins
FAST is now consolidating and recently flashed a buy signal from our internal indicator.
Options Expiration Adds Volatility
The opening looks to be higher but today is options expiration day, and anything could happen.
Chances are high stocks will sell off further, but be alert for a dead-cat bounce after such a dramatic breakdown.
Traders and longer-term investors should sell any new positions at the first opportunity and short ETFs on a temporary recovery in the market.
CAT, the blue-chip of its industry, is the first to attract attention when it's time to dress up a portfolio.
