Saturday, May 12, 2007

Equity Option Volume and Speculative Sentiment in the Stock Market

In my recent post, we saw that stocks are climbing a wall of worry, with expanding put/call ratios, even as equity prices rise. How about total option volume, however? When we have more puts *and* more calls trading, we can reasonably assume that speculators are active in the marketplace and emotions are running strong. Conversely, very low option volume suggests more placidity among speculators.

I went back to the beginning of 2005 (N = 573 trading days) and expressed each day's equity option volume as a proportion of the prior 200 days' moving average. I then assessed how a 10-day moving average of this relative volume was related to future price change in the S&P 500 Index (SPY).

When option volume over a 10-day period was 25% or more ahead of its 200 day moving average (N = 92), the next 10 days in SPY averaged a very solid gain of .89% (66 up, 26 down). It thus appears that, when emotions are frothy among stocks, returns have been skewed to the bullish side.

When option volume over a 10-day period was below its 200 day moving average (N = 123), the next 10 days in SPY averaged an impressive gain of .85% (90 up, 33 down). Interestingly, very low emotionality among speculators has also been associated with a bullish bias.

When option volume has been average or modestly above average over a 10-day period, however (N = 358), the next 10 days have averaged a gain of only .13% (214 up, 144 down). Returns have been subnormal when emotionality among speculators has not been outstandingly high or low.

It thus appears that it's not just the directional bias of option traders, but also their willingness to participate in the marketplace that helps to define the market's speculative status.


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