Part 7: Index Options. In-the-Money (IM) / Out-of-the-Money (OM) Open Interest
These graphs show you another way to classify option activity. The open interest is divided into to two classes: in-the-money (IM) and out-of-the-money (OM). These classes 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 you 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.
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 option's open interest 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. There are many reasons to buy/sell OM options but the fact that they cost less means that more investors can afford to trade them. This increases the value of speculation but when the "crowd" gets confident it will dive into OM options. When this occurs a huge jump in volume will appear and the result is that market makers and clearing firms will be on the other side of the trade.
Let's examine this more closely. Look at the SPX or the NDX in September 2003. There was an enormous spike in OM call options. But for a trade to be completed a buyer and a seller had to meet. If we assume that the small trader was buying OM options as the index was rising, someone had to cover the other side of the trade - sell it short or write it. So in comes the market maker or options dealer. They write the options. Now when the activity level dries up, prices retreat and the dealers can now have an inventory of options to work with. As prices go down, the dealers make money because the sold high and are looking to buy them back at lower prices. As prices go down, traders that bought on the way up are now losing money and they will either hold on until expiration or sell it at a loss to prevent further losses. When they finally sell it, the dealer uses their inventory to offset the traders sell order. They buy it at lower prices.
Now if the dealers end up neutral or flat, that means that the initial overreaction of buying was now met an equal reaction to sell. Now if the selling continues the dealers will need to become buyers to offset the increased demand to sell. When the selling abates and the pressure to push prices down stops, prices rise giving the dealers the opportunity to unload there purchases at higher prices which gives them a profit from their buying. In summary the overreaction to selling is followed by a counterreaction so that the dealers can redistribute the shares that they were forced to own.
However, what if the dealers weren't so lucky. What if the initial overreaction wasn't followed by a counter reaction? The answer is that the dealers are stuck on the wrong side of the trade and the first dealer who can unload his inventory at the best prices loses the least. This is identified as a longer run in prices coupled with a higher high or a lower low. If the dealers who originally sold end up with a large inventory and prices return higher, they will be forced to buy at higher prices, which will cut, or erase, their initial profits from the down move. As traders increase their buying activity prices rise and dealers must step in to meet the demand, but if dealers are now caught on the wrong side, they need to buy which adds to the buying pressure sending prices higher faster. The point of this is illustrate for you how these spikes are useful in indentifying extremes. It is at these extremes that dealers need to step in to meet the intense temporary demand created by an over-reaction and when the over-reaction has subsided, prices drift back.
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 open interest is plotted rather than the commonly used ratios. The reason for this was to search for a correlation between open interest and price, but the graphs show that open interest doesn't correlate very well with price. So now you can understand why the put/call ratio is used. First, open interest 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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