In last week's edition of Options 101, we analyzed how investors can protect against a downturn or limit losses on a stock they already own by utilizing protective puts. In today's column, we're going to take a different route by examining how heavy open interest on a stock can often act as options-related support and resistance.
By analyzing a stock's open interest configuration, traders can get a feel for the sentiment among the options crowd. Typically, a stock with a lofty Schaeffer's put/call open interest ratio (SOIR) – which measures options slated to expire within the next three months – suggests that near-term traders are relatively skeptical of the security, since pessimistically skewed puts are more popular than their bullishly biased call counterparts. On the flip side, a security with a low SOIR is generally surrounded by optimism, as calls outnumber their put rivals among short-term options.
However, investors can also utilize an equity's open interest configuration to determine potential support and resistance levels on the charts.
Large call open interest can often act as options-related resistance, especially at slightly out-of-the-money strikes among shorter-dated options. Options traders who sold these calls want the underlying stock to remain beneath the key strike, and may add selling pressure when the shares approach the highly watched level.
For example, let's assume that you purchase an ABC June 40 call, with the 40 strike already home to peak call open interest in the front-month series. On the other side of that trade are the option sellers, who must purchase shares of ABC in order to offset their option position. As the stock approaches the 40 level, the option writers will begin selling their shares in order to depress the stock price and keep their sold positions out of the money.
On the other hand, heavy put open interest can often act as options-related support. This is also partially due to the dynamics of options hedging, as traders sell puts in order to minimize exposure to risk and remain market-neutral.
For instance, imagine thousands of investors watching the same put strike level, as they want to prevent the stock from declining beyond this point by expiration. Thus, heavy amounts of put open interest can often act as technical support.
Meanwhile, in order to balance their bullish positions from selling the puts, the aforementioned put writers might sell the underlying stock short. When the options expire or when the put buyers unwind their positions, the short interest on the equity will ultimately be repurchased, which can also add to the buying pressure as the underlying shares approach noteworthy strikes.
However, not all "heavy" open interest will translate into technical support or resistance. To gauge if a particular strike is likely noteworthy enough to impact the charts: first, tally the number of open contracts at that strike that represent hedged positions; then, multiply that number by 100, as each contract represents 100 shares of the underlying stock; finally, if that number of shares represents at least 10% of the security's average daily trading volume, the strike could play a technical role going forward.
Furthermore, the effect of options-related support and resistance tends to be more evident among shorter-dated options. Since the aforementioned investors usually want their hedged bets to expire worthless, they'll typically follow the stock's price movement more closely as options expiration approaches. For example, if a trader bought an October-dated protective put on ABC, he's likely going to worry less about his position in July than, say, early October.
On that same note, strikes that are at or slightly out of the money tend to act more as options-related support and resistance, compared to strikes that are deep out of the money. For instance, if the shares of ABC are trading near the $50 level, the 30-strike put and 70-strike call are so far out of the money that it's almost pointless for the options writers to try and get the shares back on track, since they're already so far off course. Plus, these out-of-the-money options tend to harbor low deltas, making option movement modest in relation to the security's movement on the charts.
Finally, round-number levels are especially more likely to act as options-related support and resistance. Investors generally view these psychologically significant levels as good closeout points for short positions, meaning they're more likely to sell when the shares get to $90 or $100, than, say $83 or $107. On the other hand, traders tend to view round-number levels as good entry points for long positions, meaning they're more prone to scoop up a stock after it's fallen to $30 or $40, compared to a pullback to $27 or $59.
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