Saturday, December 02, 2006

A Promising Research Direction

I've begun a research project that appears at this stage to be most promising. I'll outline the basics, and you can judge the ideas for yourself.

As you know from my morning sessions and blog posts, I like to look at *how* volume trades during the day. It is very helpful to see if buyers are being more aggressive in the market place (by lifting offers) or if sellers are dominating (by transacting at the market bid). By isolating the large trades and where they occur in the bid-ask matrix, we have a good sense for whether markets are likely to be pushed higher or lower by large locals and institutions.

Suppose, however, we take this same framework and apply it to options transactions. We can separate out large options trades from small ones and see how pros vs. amateurs are trading. We can see if call option transactions are occurring in size and if they're occurring predominantly at the bid vs. offer, and we can do the same with put options.

The beauty of such an analysis is that it allows us to tease out the behavior of market bulls (call option buyers) from the behavior of bears (put option buyers), and it allows us to see when activity is skewed toward calls vs. puts or whether there is high activity in both (suggesting, perhaps, spreading rather than directional trade).

I broke down the data from Friday--which was a great trading day with several sizable intraday swings--and found patterns in the option data similar to those I have observed with Market Delta in the futures. Some of these patterns are quite like the "transitional structures" I have written about in the past: points at which buying or selling volume hits an extreme, dries up, and then leads to price reversal.

My sense is that very few short-term equity and equity index trader are using intraday options data and patterns among options traders to help them time the market. Eventually, with enough data, I plan to run historical analyses to see if, indeed, the sentiment in the options arena predicts outcomes in the stock indices. From my limited investigations to this point, it appears that the sentiment of traders who trade sentiment--puts and calls--is valuable information to the intraday trader.