Part 4: Index Option Open Interest
Option World: Specific statistics and details for each individual contract month
Legend:
The CBOE put/call ratio represents the CBOE exchange's total put volume divided by the CBOE's total call volume. However, this widely reported value may not reflect the nuance of a particular index. So we have probed into the CBOE's data and determined each individual index option's put/call ratio. Below are the put/call ratios of the CBOE's top 5 most active indices.
Below are the composite put/call ratios. We use the term composite to mean the sum of all puts and calls traded in all actively traded contract months. This produces one aggregate put/call ratio for each index option. In addition, each individual index option trades many different contract months simultaneously and each contract month can have its own put/call ratio. For a detail of each contract month ratios, visit our Option World.
Part 4
In part one, the index option composite put/call ratio and the CBOE exchange's daily put/call ratio was explained and illustrated. In part 2, the option values are used to create put/call ratios and are added to the charts. In part 3 the actual volumes are plotted and in part 4, the open interest is plotted.
Open interest represents the number of puts and calls that remain open from day to day. When a put or a call option is purchased, the volume increases by one contract. However if the trader sells this option before the end of the trading day this transaction doesn't affect the number of options held overnight. If this transaction remains open at the end of the day, the open interest also increases by one contract. When the option is sold, the option buyer closes his/her position and the position is cashed out. Either the option buyer made money or lost money, but their account is settled in cash. This isn't true for large traders who are registered with the exchange as commercial traders. They can elect to buy the underlying securities or index at the strike price instead of settling the account in cash, but for the smaller investor this isn't a choice. So below are charts of the number of contracts that are still waiting to be closed - open interest.
For example, look at the SPX option market's open interest. Notice the four sharp drops in open interest on the graph. These drops are due to option expiration. At expiration, a fair number of the contracts expire worthless and the long (this means buying a put or call) option trader loses money (the option trader who sold the pur or call option however made money- the short seller). The option trader with a worthless option doesn't need to do anything so the contract usually remains open since they have nothing more to lose (the value was already lost) and they still have a slim chance to gain their money back. So these options remain open until they expire. Interestingly the quarterly expirations are associated with a higher open interest levels and higher number of worthless options. If you examine the June 2003 expiration, you can see that the day before expiration had 215,000 option contract waiting to be closed and after expiration there were 125,000 open. This means that 90,000 options were closed on expiration. Some were worthless and some had value, but the 125,000 remaining options were due to options being traded in other months other than the front month, or June 2003. September 2003 also had a big drop in the number of options open but July and August only saw a decrease of 20,000 to 30,000 contracts at expiration.
Another observation is the difference between the number of calls and puts. Generally the total open interest is provided, but these charts break the total into its components. Notice how during the rise in the SPX in June 2003 and in September 2003 that the lines drawn by the put open interest and the call open interest are not parallel. The gap between these two components actually is getting wider. The question is did the puts increase faster than the calls or did the number of calls simply decrease? Well, if you look at the actual number of puts and calls you'll see that the puts actually increased. Another observation is that the total number of puts is lower in September than in June when the SPX made higher highs in September. Remember that puts can be used for two reasons. A trader is expecting lower prices or they are insuring their profits. So either the bears are giving up or the need for insurance isn't as great. But look at the call levels of open interest. They too aren't brimming with exuberance. As a matter of fact, the open interest of calls is lower in September than in June. This isn't an endorsement for higher prices. Basically in June. there were more option traders willing to buy calls than in September because they were more optimisitc regarding higher prices. So the sentiment is still bearish.
Now look at the XAU market. There are two glaring differences. First, the open interest, or the number of contracts still waiting to be closed is greater for calls than it is for puts and second, notice that the difference between the calls and puts is slim to none. Whereas the number of puts outnumber calls in the SPX, OEX, NDX, and DJX markets, the XAU market is bullish.
If you want to see a strong cyclic expiration then look closely at the OEX option market. You'll see the huge dropoff at expiration and you'll see the widening gap between puts and calls as the market rose in June and in September. Once again however, the open interest levels in September didn't exceed the open interest of June and the number of call options isn't increasing with higher prices. The bearish tone of the option traders is as strong as it was back in June despite the market being 5% higher. But higher prices aren't changing any traders minds, they're still bearish.
As you can see from the open interest data, despite the stock market's advance, the number of puts still exceeds calls. This is perplexing as many technicians use the put/call ratios as clues to identify market extremes. But here it is shown that the bearish sentiment can persist for months without the bears being right. So when will the bears make money? The issue being illustrated here, is that if you were to make trading decisions based on these data then you would need very deep pockets. You would need to hold on for months for prices to return to lower levels before you would see a profit. Clearly this isn't the way to trade on a short term basis.
The data clearly shows the bearish sentiment and yet the market advanced. So how are you to use this information to make money? Well, the first question you should ask is do you believe that the sentiment is correct? Is the option market telling the true story? Well, the story is simple. Investors believe that the likelihood of lower prices is greater than higher prices and so they are using their money to either protect their existing profits or they are betting on lower prices. The market participants are betting that the current rise in prices will not be sustainable and they are patiently and persistently waiting for prices to drop. The problem is that there is no conviction behind this theory as the the number of contracts isn't rising for calls nor puts. So these prices aren't "pushing" any buttons nor are they exciting traders to jump in. Traders will jump in at the extreme and you'll see the open interest explode. But that isn't happening now (Sep 2003), and so the market is searching to find price levels that will attract more volume, or investors.
If you were to apply the contrarian view then your hypothesis is that option traders are wrong. So in the SPX market you should be a buyer based on the fact that puts outnumber calls and in the XAU market you should be a seller. You'd be fighti nthe SPX and wrong in the XAU. But as you can see, doing the opposite for the sake of being a contrarian doesn't work. In the XAU market, the call option traders were correct these past few months. So if you were a contrarian you would have lost. You would have profited in the SPX and lost in the XAU as a contrarian, so your net profit would be Zero.
In conclusion, the open interest shows us the current level of confidence that option traders have in their trades by showing us how many contracts they are willing to carry. The current level of confidence in predicting future prices isn't high at the moment due to the low open interest levels. The sentiment of the market as revealed by the number of puts to calls also has not shown us to be a reliable prognosticator of future prices and leaves us wondering how much value there is in quantifying sentitment. Perhaps sentiment is useful for longer time frames, but it certainly hasn't shown itself to be useful on a short term basis as measured by the use of puts and calls. Lastly, we can see that each option market has its own idiosynchrocies. The preferred time horizon for the SPX market is quarterly while in the OEX its monthly. The level of bearishness as measured by the difference between puts and calls is greatest in the NDX market while the DJX is the most bullish.
These differences between the top five option markets were explored in an attempt to find a more profitable trading strategy that incorporates option data, but in the end there were no correlations that increased our edge in finding more low risk trading opportunities. At best these data, only served to confirm established trends and identify extreme trading days. Throughout this examination of the data, it was determined that the proportion of the underlying forces that compel traders to use options could not be measured. The number of options traded for the purpose of insurance versus trading eluded us, and hence devalues the accuracy of its use as a forecasting tool and limits any further interpretation of the results.
created 9/19/03, ©2003 The Small Investors Software Co. All rights reserved.