Part 9: Index Options. In-the-Money (IM) / Out-of-the-Money (OM) Flips
Let's examine another another unusual view of option data. These graphs illustrate the amount of day trading that occurrs every trading day. Essentially these graphs were created in an attempt to identify "panic" levels of trading.
First let's define a "flip". It's a day trade. A flip is simply a trade that is opened and closed the same day. It could be a buy and sell or a sell and a buy. The important aspect is that a complete trade was made within one day session. No overnight trades qualify. Using option data, the manner in which flips are computed is also an easy calculation. First the change in open interest is computed. This represents the number of trades that were or weren't closed in the previous session. An positive change from the previous session indicates more trades weren't closed and a decrease in open interest implies more trades were closed. So to determine the number of trades that were completed in one session, the change in open interest is substracted from the volume. The result is the number of day trades.
This figure unfortunately isn't a "pure" number. While in theory this makes sense, it is possible for previously existing open positions to be closed. These trades would appear as day trades, but given the data provided by the exchange, this activity can't be distinguish from a "pure" day trade and thus the figure that is computed is technically a combination of day trades and closing position trades. Another abberation that isn't obvious is due to accounting/clerical errors. The exchange doesn't revise volume data when errors in accounting are discovered and are rectified. However, the open interest figure is revised when clearing firms correct for these errors. So discrepancies due to the clearing process affect the "pure" number of day trades. The number of flips is therefore a best estimate of the number of day trades since the exchange doesn't issue revised data after corrections for these back-office accounting/clerical errors have been made.
Now let's explain the interplay between volume and open interest. First let's identify that open interest can either increase or decrease. If open interest increases this means that trades were initiated but they weren't closed. One would assume that the volume for the day could not be lower than the change in open interest because if a trade was made the volume increases by one. However this assumption is wrong as there are many days in which the change in open interest exceeds the daily volume reported.
One critical fact that you may not be aware of is that open interest data is a day behind the last price and volume data reported by the exchange. In other words, the daily quote that the exchange issues is a composite. The pricing and volume information is current but the open interest data doesn't represent the open interest of that day. It represents the previous trading session's open interest. This is done intentionally because open interest data isn't complete nor final until after all trades have been cleared. This process occurrs after the market closes and the updated open interest is posted around 4-5AM Central Time. This enables traders and brokers to adjust accounts before the start of the next trading session. However this information isn't available when the settlement prices are reported every evening. So the exchange posts only the final updated open interest which is one day behind the pricing data.
This is important when computing differences and determining values involving open interest figures. As stated earlier, there are many instances when the change in open interest exceeds the daily volume, but this occurs despite the adjustments made for the reporting of the data. The official response from the Exchange is that accounting/clerical errors certainly accounts for a portion of this anomaly, but since no other explanation has been offered by the exchange, apparently all of these differences are due to errors. This is disturbing to see that the exchange's error rate can be as high as 16% of the daily traded volume of calls or puts. That means 1 in 6 trades was errant. Now there's something that they want to keep a secret. This was an unexpected discovery in this exploration into option data.
In this study, the open interest is divided into to two classes: in-the-money (IM) and out-of-the-money (OM). These classes of options refer to the option's intrinsic value and not to its current price. All options are worth something prior to expiration, and that value is the current price reported by the exchange. But not all options will add money to your account when they expire. Those that expire worthless are the OM options, and the ones that do payoff are the IM options. Also note that IM options cost more than OM options. This fact helps us to explore the behaviour of traders who are hoping for the long shot to come in versus the behaviour of traders who have more money and play it safer.
Each trading day an option may or may not have any activity or interest. When a buyer and seller meet, one transaction has occurred and the volume of activity increases by one contract. This immediately becomes an open position because now you have buyer who needs to sell and a seller who needs to buy in order for these two traders to complete their transactions. (For your information, an option trader does have a third choice besides buying or selling. The trader can choose to exercise his/her right of the option. For example, if one of the traders bought a call option, he/she could either sell the option before expiration day or exercise their right to purchase the underlying index at the strike price. The trader who sold the call can either buy the option before expiration or exercise their right to sell the inderlying index at the strike price.) Now if these traders are confident in their decision they will hold on to their option overnight. When this occurs, the open interest increases by one contract. So open interest is a measure of confidence. It tells us how many traders are confident in their decision and are holding on to a position.
Once the number of flips is computed, all of the options are classified as either IM or OM. The manner in which IM/OM options are classified is simple. At the end of each trading day, an assumption is made. The assumption is that each trading day is treated as if it were expiration day so that the options can be classified. For calls, if the strike price of an option is less than the closing index price then that option is an IM option and if the strike price is greater than the closing index price then the option is an OM option. So each flip is assigned to one of the two classifications. For puts, it's the opposite. If the closing index price is greater than the strike price then it is an IM option and if the options strike price is less than the closing index price then it is classified as an OM option. once each strike price's options have been classified the total number of flips is computed.
Below is a matrix of graphs for the five index options. As mentioned in the table of contents, option data is dense and it produces a an extraordinary number of combinations. As an example, the following matrix of graphs illustrates this complexity. Each column represents one of the five indices and each row compares the open interest of the IM/OM options is various combinations.
As you can see, the raw number of flips is plotted rather than the commonly used ratios. The reason for this was to search for a correlation between flips and price, but the graphs show that flips doesn't correlate very well with price. So now you can understand why the put/call ratio is used. First, flips doesn't correlate to price and secondly, ratios are used because of the frequent spikes found in these graphs. Ratios are a handy mathematical expression that effectively converts these spikes into little blips. Generally, you can expect spikes at expiration, but they occur more frequently than that.
Basically, notice when IM and OM options differ and when their they have the same reaction. These responses will give you a clue as to how identify turning points in the market.
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