Index Option Trading: Finding an Edge

Back in my Duke days, signs came and went in the basketball team's locker room. One sign, however, never left the wall: "Acknowledge the pass that leads to a score."

It's a great motto for success in life, as on the court.

My Weblog offers links each day as my way of acknowledging those who are doing great work in educating traders. A special shout out, however, goes to Adam Warner and Jason Goepfert, who have helped me think about options in new ways. Both are affiliated with the excellent Minyanville site, which also offers a tutorial on options and derivatives.

Today, we'll look at options traded on stock indices, not on the individual equities themselves. It is vitally important, when analyzing option activity, to separate out these components. Why? Since March, 2003 (N = 816 trading days), the correlation between the put/call ratio for the equities and the indices has only been .11. Interestingly, their volume correlates highly (.79), suggesting that participants in the index and individual option markets are utilizing different strategies, but using them at the same occasions.

Thursday's market (SPY) rose more than 1% on the day. Since March, 2003, we've had 78 occasions of a rise of 1% or greater. If we break those occasions into halves based upon the index option put/call ratio, a very distinct pattern emerges. When SPY has risen more than 1% and the index option put/call ratio is high (N = 39), the next three days in SPY average a solid gain of .46% (30 up, 9 down). When SPY has risen more than 1% and the index option put/call ratio is low (N = 39), the next three days in SPY average a subnormal .07% (22 up, 17 down).

It thus appears that, when index option players are hedging a strong rise, this has more bullish implications over the short-term than when there is little such hedging.

Although the put/call ratio for the individual equities correlates so modestly with the ratio for the indices, the same pattern is present. When SPY rises more than 1% on the day and the put/call ratio for individual equities is high (N = 39), the next three days in SPY average a gain of .48% (27 up, 12 down). When SPY rises more than 1% on the day and the put/call ratio for individual equities is low (N = 39), the next three days in SPY average a subnormal gain of .05% (25 up, 14 down).

It looks as though it pays to buy when option players are skewed toward the put side--but it also seems that the option players in stocks vs. indices become skewed at different times. On Thursday, we saw a relatively high put/call ratio in the stocks, but not the indices. In the recent past, when this has occurred, it has been bullish for the next day, but not thereafter (though the sample size is small).

P.S. - Here's my article on the most important theme in today's market.