Using Gamma to Find Trade Ideas

MKC and TNDM stocks are potential short-term trade candidates based on this options-related indicator

by Rocky White

Published on Nov 6, 2019 at 7:30 AM
Updated on Nov 6, 2019 at 7:30 AM

Our Schaeffer's put/call open interest ratio (SOIR) measures the amount of put open interest relative to call open interest, using expiration dates within the next three months. A high number for this ratio indicates a lot of puts compared to calls. Another indicator that we use at Schaeffer's is an expiration-specific gamma-weighted SOIR, which we usually call the front-month (FM) gamma SOIR.

Gamma is one of the option Greeks that are calculated using option prices. Delta, another Greek, tells us how much an option price will change depending on a change in the stock price. Gamma then tells us how much delta will change. What's important for us is that strike prices that are closest to the stock's current price will have the highest gamma. Therefore, when we weight the open interest using gamma, the strike prices nearest the stock price will be most relevant and the strike prices that are far away from the stock price become meaningless. This is especially useful for stocks that have moved significantly. In these instances, there might be a lot of worthless open interest sitting far out of the money that skews the traditional open interest ratio.

This week, I'll dive into how we use this indicator, and list stocks that have noteworthy gamma-weighted SOIRs. I'll consider only options that expire next week (Nov. 15). This is clearly a very short-term indicator since in about a week, when these options expire, the front-month gamma SOIR will be using a whole new set of options, thus making the current reading irrelevant.

High Gamma-Weighted SOIRs

First, here's a quick list of S&P 500 Index (SPX) stocks (which met certain liquidity criteria) with the highest FM gamma SOIRs. These are stocks which have a buildup of put open interest (OI) at strikes near the current stock price. If this was the only indicator to consider (which it's not), we would tend to be bullish on these stocks, as the large number of puts indicate a level of pessimism on the stock. Additionally, we view large put OI at a strike as supportive for the stock, as it limits the downside.

11.5 iotw chart 1

Drilling Down Into MKC

I'll drill down on McCormick (MKC) stock from the table above. On a chart, the stock pulled back to the $155-160 region on Monday, and it's bouncing a little today (I'm writing this on Tuesday afternoon). The chart below shows the put and call open interest that expires on Nov. 15 for MKC at each strike. The pullback put the stock price where a bunch of put open interest sits. It's clear this stock will have a high gamma-weighted SOIR at this point. We might expect those huge 155-strike puts to act as support for this stock so this could confirm a decent entry point for a trade.

11.5 iotw chart 2

Now I'm going even further to see how this indicator has performed as the sole driver on a short-term trade. I went back to 2015 and looked at stock returns in the seven trading days before expiration, based on what the FM gamma SOIR was. The scatterplot below shows the results (again, I only considered times that where the stock met liquidity criteria, so there won't be a return for each expiration date).

With the current gamma SOIR at 3.34, you could make a bullish case that the two times the reading was at a similar level, it led to returns of about 3% and 5% -- very good returns for a trade of less than two weeks. On the other hand, using a regression analysis on the returns and the FM gamma SOIR seven trading days from expiration, the R-squared is low, suggesting the indicator may not have a lot of influence on the stock return.

11.5 iotw chart 3

Potential Trade Ideas

Using a regression analysis on all stocks meeting some liquidity criteria, I came up with a couple lists of stocks. Specifically, after running the regression stats, I only considered stocks that had an R-squared value of 10% or more. A 10% value may not seem high, but considering a sole indicator on short-term stock returns, that's actually quite significant. That's why trades should not be based off a single statistic.

I also only used stocks in which the slope of the regression line is positive, telling us the higher the FM gamma SOIR, the higher the expected returns. Some stocks have a negative slope, meaning the data shows the opposite of how we interpret the indicator. Our assumption is that other factors had a much bigger affect on the stock returns, unless we have a theory on why the indicator would act in this matter. For example, for exchange-traded funds (ETFs) that are often used for hedging, high put open interest can actually be interpreted as bullish sentiment, since the puts are purchased to hedge long positions in individual stocks.

Finally, using the regression equation, the list of potential bullish stock trades only shows stocks with an estimated return of 1.5% or more when you plug in the current FM gamma SOIR. Doing that gives the following eight stocks.

The first one on the list, Tandem Diabetes Care (TNDM), shows an expected stock return of 25%. Obviously, you really don't expect the stock to return that, but I wouldn't ignore the indicator on that basis. Again, these are stocks that I would look to do more research on to support a bullish short-term trade, or maybe to confirm an entry point on a longer-term trade.

11.5 iotw chart 4

Last, I have the list of stocks expected to lose 1.5% or more from now until Nov. 15 given the regression equation discussed above. These are stocks with low FM gamma SOIRs, indicating they're currently trading near strikes where there's a buildup of call open interest.

11.5 iotw chart 5


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