Sunday, June 28, 2009

How Options Matter…

I was wondering for a long time that it is so easy to say as to why and how the options sway the markets – like it the call build up is more then the markets are less likely to go up and vice versa. Is it true? Is it sacrosanct? I started looking for the answers and when it came to the brass tracks of getting a precise answer there was so much that it took me time to comprehend. At the end I gave it a thought whether or what is the right one. In any case i am putting forward what little I learnt and will share it here. Only thing is – like I always say – I do intend to use this site for not only getting my ideas out of the head but also to learn myself. There are stalwarts in trading in general and in options in particular – and would be grateful if there is some contribution from all who read so that we learn more.

Okay the Question that I deal with today is “How does call and put build up matter'”. Well here I go from what I gather. In this theory it works with the premise – in the words of Humphrey Neill “The public is right during the trends but wrong at both the ends”. There is a lot to read in between the lines here.The Put/Call ratio (the ratio of the trading volume in puts to the trading volumes in calls) is an important sentiment indicator. As a contrarian , the belief is that when to many speculators are bullish (indicated by a low Put/Call ratio), the market is poised to fall or atleast consolidate within a bull trend. And just as this ‘wrong way’ crowd becomes exuberant at market tops, it feels gloomiest at the market lows. What is of special interest is that at the extreme readings in the Put/Call ratio these points this indicator becomes the most reliable. Just as high Put/Call ratio indicates excessive pessimism and thus signals the significant lows in the markets to contrarians, a very low put/call ratio is similarly a bearish omen to the contrarians. Now by identifying extremes in public opinion, Put/Call ratio should offer one of the most valuable tool to predict the market turning points.

Another point to the options that is often agreed upon by those who deal in options is that the up trends in the markets are generally gradual over a greater period of time and down trends are sudden and swift. Both these circumstances have to be dealt in a different time frame and in a different manner.

The second question to which I found and interesting answer was as to “Why are there points in Options referred to by experts as the strike prices that are significant?” Okay these are significant because of Delta hedging. Okay here goes the explanation – Often, there is a build-up of call open interest at key strike price that is significantly out-of-money on a stock or index. Those people who sell these calls run the risk that a rally in the underlying stock will risk the options sold. So they hedge these by buying shares in the stock. But of these far-out strike prices, call sellers have little incentive to hedge their risk (which costs money), as the small amount that these ‘low delta’ options will move relative to the movement in the underlying stock does not pose significant risk. However, as the stock or index starts moving toward the strike, the call sellers need to buy the stock or index in increasing quantities to hedge the risk and remain ‘Delta neutral”, as their negative delta increases due to the increasing possibility of these options moving into-the-money. Such a process of hedging more of the underlying as it moves closer to the money is known as Delta Hedging.

Now let us understand what happens when the strike is reached. At that point , call sellers will likely be hedged, and they will have plenty of incentive to sell the stock, index or future to keep the options they sold from finishing in-the-money. This often creates downward pressure on the stock or index. Thus, artificial buying on the way up is converted to increased selling pressure once the strike is reached. Consequently, heavy out-of-the-money call build-up can be bullish in short term, yet bearish in the longer term. Now comes the second part of this dilemma – if the strike with big call open interest is significantly penetrated due to continued heavy demand for the stock, the delta hedging process will result in further upside impetus as the call options sellers scramble to buy even more stock. This same principle applies to a large build-up of put open interest on a stock or index.

So now how do I play these places where such build-up takes place? Firstly be cautious: never assume in advance that an option strike is ‘impenetrable’. It’s suggested to wait for an odd day around these points and at close take positions with the winning side.

I hope that I have been able to present the above in as easy language as possible and will help people study the options data and use it well. Best of luck and I have a question – how do I identify extremes of the public opinions? I will be grateful if someone can point me out the answer.



r m said...

Thank you Paaji for this scholarly and yet so easy to understand writeup!

S S Cheema said...

thanks for the pep up rm.