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Charting the Importance of Call Open Interest Peaks

Four charts show how extremes in option activity can reveal impending price shifts

by 7/9/2013 9:31 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the July edition of The Option Advisor, published on June 27. For more information or to subscribe to The Option Advisor, click here.

The tools available to our analysts for slicing and dicing activity in the options market here at Schaeffer's Investment Research are quite daunting. We maintain our own options database going back to the 1990s from which we perform various proprietary analyses, and we also make extensive use of Henry Schwartz's extremely impressive Trade Alert options data that's organized in numerous useful configurations.

But sometimes, a visual approach that keeps it simple can provide us with powerful conclusions that belie this simplicity. And I feel this is well illustrated by my notations on the accompanying Trade Alert charts for Apple Inc. (AAPL), Best Buy (BBY), Krispy Kreme Doughnuts (KKD) and Netflix (NFLX). Each of these charts displays historical total call and put open interest levels (indicated in green and red, respectively) as well as share prices. And the common theme can be expressed as "Be very aware of call open interest peaks, as such peaks can alert you to significant share price movement ahead, often in a contrarian sense."

Though the details are noted on the charts, let's examine the major premises for each of these four very interesting situations.

AAPL – No one needs to remind us in retrospect of the extent to which this stock was venerated by the investment community at the time of its share price peak in September 2012, but call option players took their "Apple worship" to a whole new level. Total call open interest for AAPL was already at record levels at an astounding 2 million contracts as the shares reached their pinnacle (astounding also because of the high dollar cost for each AAPL call contract due to the $700 share price). But even as AAPL shares proceeded to plunge by 200-points from their September highs into year-end 2012, an additional 700,000 contracts in call open interest was accumulated (with the final call open interest peak in January 2013). A contrarian would suggest that the ongoing enthusiasm for the shares as expressed by the continued growth in call open interest well beyond the price peak was an indication the stock had further to decline before capitulation (and a bottom) could be claimed, and this proved to be very much the case. (Click on the charts below to enlarge.)

Apple (AAPL) Daily Open Interest

BBY – Here was another huge peak in call open interest -- this time in December 2012 at 535,000 contracts. The subsequent implosion in call open interest is detailed on the chart, which occurred as the share price more than doubled in less than 6 months. Perhaps many of these calls had been held by short sellers who used them as a hedge against a rally, in which case they were certainly very right about being very wrong.

Best Buy (BBY) Daily Open Interest

KKD – I see this as a classic case of bullish investors giving up on a stock that had been dead money for many years -- at just the wrong time. The last time any enthusiasm had been worked up for KKD shares in the form of call activity was in mid-2011, and the bulls were "rewarded" by a 40% stock price decline in 3 months. Not long after this debacle, KKD options in effect began trading by appointment only, and even a 50% year-to-date gain just ahead of their late-May earnings report failed to attract any call play. So the additional 30% post-earnings rally was like that tree falling in the forest as far as it affected the options world.

Krispy Kreme (KKD) Daily Open Interest

NFLX – The surge in the call option play that accompanied the plunge in NFLX shares from $300 to $60 in the second half of 2011 was huge, with well over 300,000 open call contracts nearing year-end. Perhaps a chunk of this play did not relate to speculators attempting to catch a falling knife, but you have to figure a bunch of it most certainly did. And what of the big 2013 rally in which NFLX is trading 131% above its year-end 2012 level as of today's close? NFLX call open interest remains in steady decline, and a mere 112,000 calls were open as of this morning. Is more upside therefore likely before the next NFLX peak? That would be my take.

Netflix (NFLX) Daily Open Interest

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