How Heavy Put Open Interest Can Impact Stocks

The following is a reprint of the market commentary from the December 2015 edition of The Option Advisor, published on November 19. For more information or to subscribe to The Option Advisor, click here.

As equity analysis tools go, a stock's option open interest configuration can be particularly revealing. Not only do heavy open interest strikes provide valuable sentiment clues, but they often coincide with key technical levels for the underlying stock -- and, in fact, these major open interest accumulations can themselves influence a security's price action.

Regular readers of this newsletter know that we often cite the concept of "put-related support" in our bullish recommendations, and this month we'll explain in greater detail how these options-trading mechanics work.

In order to begin at the beginning, let's first state that "open interest" refers to the total number of option contracts that have been opened, by either buyers or sellers, at a given strike. And it's important to note that for every option buyer, there is an option seller who has taken up the opposing end of the trade. In other words, option open interest is controlled not only by option buyers, but by option sellers -- and at least one of these parties is often a market maker, who are typically hedged players.

It's very common to find major put open interest concentrated at levels either at or below the stock's current price -- i.e., at-the-money or out-of-the-money strikes. This is especially true of some of the broader equity-based ETFs -- such as the SPDR S&P 500 ETF Trust (SPY), PowerShares QQQ Trust (QQQ), and iShares Russell 2000 ETF (IWM) -- which have gained popularity among those looking to hedge their long stock positions.

When we refer to "heavy" or "significant" amounts of put open interest -- the kind of accumulations that we would expect to provide structural support for the underlying stock -- we're not referring to a single, hard-and-fast number of contracts. However, as a general rule of thumb, we view it as significant when the open interest at a given strike controls a number of shares equivalent to 10% or more of the stock's average daily volume.

There are a few primary reasons why massive put strikes can provide support. From a sentiment perspective, it's possible that a huge build-up of put open interest at a particular price point is indicative of climactic pessimism, which we would expect to coincide with the exhaustion of selling pressure. Once the stock attains this expected "bottom," it then takes relatively little buying power for the shares to stage a reversal.

From a more mechanical perspective, the accumulation of open interest that results from traders who sold put options at a given strike can influence the stock's price action. Those who sell puts to open are betting that the stock remains above a strike through expiration, and are seeking to pocket the premium of the option at expiration (or they are willing to buy the stock at the strike price if the stock is "put" to them). As the shares draw close to a heavily populated put strike in which the options were sold to open, those who purchased the puts in order to facilitate the transaction -- possibly market makers -- must buy more stock in order to hedge their purchased puts, and keep their risk exposure on an even keel. This activity creates an automatic bid for the stock as it approaches the strike in question.

And on the other side of this equation, put sellers who neglected to hedge their bets may step in to buy the stock as it approaches the strike, in order to keep their "naked" puts out of the money and prevent losses.

To quickly find stocks that may be poised to benefit from such put-related support in the short term, we've developed an indicator we call the gamma-weighted Schaeffer's put/call open interest ratio (SOIR), which you've likely seen cited in some of our Option Advisor trade recommendations. You can learn more about gamma in our Education section, but the important takeaway is that at-the-money options have much higher gamma relative to those strikes that are farther away from the stock's price.

Our gamma-weighted SOIR is calculated to hone in on options with higher gammas -- and as a result, this indicator is a useful measure of near-the-money open interest, while largely "filtering out" open interest that is either deep in the money or deep out of the money. Gamma-weighted SOIR readings over 1.0 suggest a prevalence of at-the-money puts relative to calls, which can be a supportive factor for bullish options plays.

So we've explored how stocks find support at put-heavy strikes near their current price -- but what happens when put open interest is concentrated at out-of-the-money strikes, and is mostly driven by those who purchased the puts to open -- perhaps as portfolio protection, or a speculative bet that the underlying will decline? In this scenario, the popular put strikes can actually act as a "magnet" to draw the underlying security lower, particularly as expiration approaches. That's because whoever sold the puts (likely a market maker) only had to partially hedge the position by shorting the shares, because the out-of-the-money option wasn’t particularly sensitive to the underlying’s price movement at the time of initiation. But if the stock begins to decline, the option becomes more and more sensitive to the underlying’s movement, and the motivation grows to hedge the sold puts by shorting more and more stock. As shorting activity increases, it accelerates the stock's move down toward the focus strike -- which, in turn, necessitates more shorting by hedged players.

This process, known as "delta hedging," may not end until the option is experiencing a point-for-point move with the underlying, at which point the seller of the put is fully hedged via a short position in the underlying. While volatility around such heavy put open interest strikes might occur during these instances, it is usually an area of support, as the delta-hedge selling usually contributes to short-term exhaustive selling (occasionally accompanied by a brief, sharp move below the "magnet" strike). However, If there are additional accumulations of heavy put open interest at deeper out-of-the-money strikes, these may also act as magnets to draw the shares lower and exacerbate the decline.

We've witnessed this magnetic effect on SPY more than once during expiration week, as well as its major equity ETF counterparts. In fact, during the mid-August sell-off, IWM broke below peak put open interest at the at-the-money 120 strike, and then was quickly pulled lower by the glut of open puts at the 117 strike -- a possibility our Senior V.P. of Research Todd Salamone had warned of in that week's Monday Morning Outlook. As a result, only 37.8% of August-dated IWM puts expired worthless in August, down sharply from the average of 91.1% over the first seven monthly expiration cycles of 2015.

With this in mind, it's safe to say that the importance of studying open interest configurations extends well beyond the realm of researching individual stock trades. In addition to highlighting levels of potential support, getting in the habit of locating put-heavy strikes can help you prepare for possible broad-market moves that may have a wider impact on your entire equity portfolio.