This is the second article in the series, be sure to read How to Track Options Volatility – Part I.
Let’s examine the difference between option trade volume and open interest ratios, and what each one is measuring, to see how it might or might not be helpful.
Short-term traders often watch the intraday volume of puts compared to the intraday volume of calls. During the day, the Chicago Board Options Exchange (CBOE) posts an aggregate volume for the contracts it trades, and the put/call ratio based on that volume is posted to its website about every 30 minutes.
Drawbacks to Using Put/Call Ratios
While this may be somewhat helpful, there are some drawbacks that can make this ratio potentially misleading. First, this volume is for contracts traded on the Chicago Board Options Exchange (CBOE) only, and it’s only updated about 12 times a day. Most options are now listed on multiple exchanges, and the International Securities Exchange (ISE) actually does more equity option volume now than the CBOE does. Volume could be significantly lighter or heavier on another exchange.
Another drawback to put/call ratios is that, even though we can access individual exchange volume data during the day, there’s still no way to know what portion of the volume was closing customer transactions and what portion was opening customer transactions.
As a result, it’s impossible to know whether the trades you see will result in an increase or decrease in the open interest calculation. This is the main reason why daily volume put/call ratios are of somewhat limited value.
To understand why this can be misleading, consider this example: If open interest yesterday on a particular option was 1,000 contracts on the calls and 1,000 contracts on the puts, the open interest put/call ratio would be 1.00. Assume today’s volume is 400 contracts on the puts and only 100 contracts on the calls. The daily volume put/call ratio would be 4.00.
While four puts trading for every one call contract may seem to reflect very bearish sentiment, it could be exactly the opposite of that. You can’t simply assume that all 400 put contracts were opening positions. If all 400 put contracts were closing trades and all 100 call contracts were opening trades, then tomorrow’s open interest would be 600 on the puts and 1,100 on the calls, for an open interest put/call ratio of .54.
This might indicate that today’s traders were bullish, not bearish. If you are going to watch daily volume put/call ratios, you may want to consider viewing a 21-day average volume, which combines trades from all exchanges. You can then look for trend changes rather than simply looking at a single-day spike on a single exchange and assuming that a major sentiment shift has taken place.
The third drawback to viewing daily volume ratios is that, while the CBOE calculates the ratios based on equity volume and index volume individually, much of the equity option volume is retail trading, while institutional traders tend to comprise the bulk of the index option volume.
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It’s possible that the equity ratio could be very high, while the index ratio is very low. If you combined the two, they might cancel each other out and appear to indicate a balanced sentiment. If you’re going to look at the ratios intraday, you may need to decide which one has more validity.
Open Interest Put/Call Ratios
Because there are far more option strategies that involve holding a contract over a period of time instead of trading intraday, the open interest put/call ratio may be more helpful. The open interest is not calculated during the day or by an exchange.
Rather, it’s calculated each night by the Options Clearing Corp. (OCC) once the day’s trades from all exchanges are matched. Because the open interest indicates the number of contracts outstanding, it can be a helpful measure of sentiment over a given period of time. The OCC posts the open interest put/call ratios each day, but the OCC only calculates the ratio based on the combined equity and index values.
Because the open interest on equity options tends to be about 15 times what it is for index options, the combined ratio almost always reflects the level of the equity ratio. Through my research, I’ve found that when I separate equity and index values, the open interest put/call ratio on index options appears to be a much more accurate contrarian indicator of market sentiment than the equity ratio.
While the chart below only shows open interest put/call ratios, I’ve marked major market tops with green vertical lines and major market bottoms with red lines. What I find interesting is that, in many cases, the ratio for index options (black graph) peaked near market highs and troughed near market lows.
At the same time, it was difficult to recognize a trend in both the ratio for equities (pink graph) and the combined ratio (green graph), regardless of which way the market was headed. As you can see by the yellow trend lines, the index ratio shows much clearer trends, both up and down.
I’ve been tracking this data for about seven years, and although I find it helpful, it may be easier to focus on the trends that have occurred in the past year or so. Below is another chart depicting only the SPX (black line) and the open interest put/call ratio on index options (red line).
Because open interest tends to drop sharply on each monthly option expiration, I’ve also added a 21-day moving average (teal line) to smooth out the data. As in the longer-term chart, the ratio seems to rise and fall with the market (supporting its contra-indicator tendencies), but at times seems to change directions before the market.
Although I’ve found this data to be more reliable than the VIX, as with any statistical or technical indicator, be careful about relying on it too heavily. My main goal is to make sure that you understand the different types of put/call ratios that are used–and to caution you not to read things into them that may not be there.
Randy Frederick is Director of Derivatives at the Schwab Center for Financial Research. To learn more about him, read his bio.
This article originally appeared on The Options Insider Web site.
