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Using Options to Gauge Sentiment

Examine options data to measure market sentiment toward specific equities

by 10/30/2012 2:01:53 PM
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In this article, we're going to take a look at options as a sentiment indicator. As you may or may not know, sentiment analysis is a key component of Bernie Schaeffer's Expectational Analysis« methodology (and if you count yourself among the unaware, please check out this link). However, judging by some of the questions we get from our readers, there's a bit of confusion as to how option activity factors into the sentiment picture. For a comprehensive breakdown of some oft-cited indicators, keep reading ...

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

This indicator is exclusive to Schaeffer's, as the name suggests. Because our primary focus is near-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.

Therefore, readings above 1.0 suggest that puts outnumber calls among short-term options. Conversely, readings below 1.0 indicate that calls are more prevalent, while an exact reading of 1.0 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, maybe the stock is perpetually beloved on the Street, and it's generally surrounded by high hopes.

In any event, we put the SOIR into 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 12 months. On the flip side, a 100% ranking tells us that short-term traders are favoring puts over calls more than any other time during the past year.

Of course, open interest doesn't necessarily fill in all the blanks, because this indicator doesn't differentiate contracts that were bought to open from those that were sold to open. Many readers have asked 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 one indicator taken out of context.

See, Expectational Analysis« is based on the notion that investors should examine a potential trade from several different angles in order to get a handle on all of the catalysts that could impact 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 tandem with other sentiment indicators, I strongly suspect you won't be led astray.

ISE, CBOE, and PHLX volume ratios

Daily put/call and call/put volume ratios from the International Securities Exchange (ISE), the Chicago Board Options Exchange (CBOE), and the NASDAQ OMX PHLX (PHLX) are other useful sentiment tools, 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 security.

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 short interest is extremely elevated, 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 framework, 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, though, this is proprietary data that Schaeffer's receives from the exchanges, so the average trader can't access this information with the greatest of ease. Fortunately for you, we're generous options fanatics, so we do our best to share this data.

Our Daily Options Blog on SchaeffersResearch.com includes charts that list the day's most notable call and put activity. These tables are easy to scan, so they're a great jumping-off point for your research. Plus, we cover several stocks that have piqued our 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. The objective of these daily columns is to drill down for a closer look at a specific equity'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 lack of out-of-the-money calls could point to very low expectations for the stock to tick higher.

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 range-bound, 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 a "speed bump."

So, these 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 rookies, but with a little education and practice you can become an options-analyzing pro in no time.

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