With regard to Expectational Analysis®, we believe that open interest (rather than options volume) is the best tool for analyzing option activity. It is a much more stable number and it reflects what option traders are doing "at the end of the day." Large volume could be indicative of transient day-trading activity (which has no impact on open interest) or could reflect traders closing existing positions (so if there is big put volume on a given day, this could be simplified as a reflection of bearish sentiment, when in fact it indicates that bearish bets are being closed).
That said, the advent of hedge funds, exchange-traded funds, and other trading vehicles has created a very different options world than we experienced just a few years ago. The primary driver of option trades these days is the seller, not the buyer. So if call activity is being driven by those selling calls against stocks and put activity is being driven by those selling naked puts - with each of these strategies reflecting a slightly bullish outlook for the underlying asset - what does a "put/call" ratio mean these days?
There is still a way for practitioners to use the put/call open interest ratios as market indicators, not so much in a sentiment sense as in a sense of structural options-related support. When open interest put/call ratios for the key indices and exchange-traded funds (ETFs) – such as the SPDR S&P 500 ETF (SPY), PowerShares QQQ Trust (QQQ), and iShares Russell 2000 ETF (IWM) – are high, there is a notable shift in how these instruments behave.
Large put open interest in aggregate almost always means large put open interest at the various strike prices at or below the current price of the underlying asset (i.e., at the money and out of the money). Because of the dynamics of options hedging, those on the other side of the put selling trade - who've bought the puts from the sellers - hedge their positions by being long on the underlying stock. If the market declines, they buy more stock to offset the increased value of their puts. Hence there is a built-in "bid" for the market as it declines, and the more the market declines, the bigger the bid. Strikes home to heavy out-of-the-money put open interest represent intangible support zones, as indices, funds, and stocks tend to bottom out as they approach these levels.
While such put support has really taken center stage, especially in recent years, there is still a flip side to this scenario of options-related support. Strikes at which there is heavy out-of-the-money call open interest potentially represent resistance. Those who sold the calls have a vested interest in seeing the stock remain below the key strike, and may induce resistance by adding selling pressure when the stock approaches this critical level.
Round-number levels are especially prone to serve as support or resistance, as investors view pullbacks to such levels as good entry points for long positions or potential closeout points for short positions. In the same fashion, traders will sell their long positions or go short following rallies to round-number levels. Heavy open interest at these strikes can emphasize the support or resistance already inherent at psychologically significant levels.
There is naturally the caveat that these sites of heavy open interest do not always act as precise resistance/support levels. For example, when call or puts are heavy at far out-of-the-money strikes, most of the written options are unhedged because of the low deltas for out-of-the-money options. There is little incentive to hedge one's risk when strikes are far out of the money, as deltas are low, making option movement modest in relation to the stock's price changes.
However, as the stock moves closer to the out-of-the-money strikes, those that sold these options will feel more pressure as the delta increases, thus forcing hedging activity. As options investors buy up the underlying shares or short the stock – depending on whether they have sold puts or calls – the stock might experience temporary surges through the strike price due to an imbalance in supply and demand created by this hedging process. This process of hedging more of the underlying stock as it moves closer to the strike price is known as delta hedging.
When a lightly traded stock (or one for which supply exceeds demand) overcomes potential call resistance due to delta hedging, the move will typically reverse quickly back below the strike price as hedging activity begins to decrease. On the other hand, a strong stock will likely stay above the strike price, as non-hedging demand continues to be stronger than supply. Also, if there is a significant penetration of the strike price due to this heavy demand, additional demand from the delta-hedging process can add to the upside momentum.
The important lesson is that it is advantageous to be aware of open interest at various strike prices to know why a stock behaves in a manner that most other investors and traders might not understand. Such knowledge can give you the edge needed to give your portfolio a boost.