What if open interest is skewed one way?

Discussion in 'Options' started by timetotrade, Feb 1, 2008.

  1. How important is open interest when it comes to analyzing future price movement of the underlying stock?

    For instance, take CCRT. The P/C open interest is almost 2.5/1 and the stock has apparently made a bottom and is heading higher. OTOH, take a stock like MCO with a P/C open interest ratio of almost 2.5/1 but it is still in a downtrend and has not started heading to the upside.

    Does a high open interest P/C ratio signal pessimism on a stock and could this be bullish once a stock makes a bottom and turns up? IOW, despite the upward momentum for CCRT, there is still bearish sentiment which could fuel further upside?
  2. If I understand you correctly, The main reason of your exercise is to find an edge. There are three types of edges (you can subclassify of course and have other types):

    1. The certain edge. This means that your edge will cut your opponent but never cut you, and you are certain.
    2. The probabilistic edge. The one that cuts you and your opponent. But over all, which means multiple fights with your opponent, you end up bleeding less than him, and you win at the end.
    3. The almost certain edge. Is the edge in between 1. and 2. It is the edge that you can rely on and have proof, that with a probability of almost one, you will win on each trade. But it is not certain.

    All the above types of edges exist.

    Now how one can go about finding such edges? Your best friend: Same causes lead to same effects is a scientific principle. This requires one to think under the surface, and present a logical explanation. Then one uses numbers to ascertain whether or not one has a correct thesis.

    This usually leads to an edge of type 1 or type 3.

    What if you did not have the chance to build a model of causes and effects, or just want to reduce your search time for such solid edges? Answer: You can do what you seem to be doing:

    1. Find correlations between a variable A and a variable B.
    2. If there is a correlation (negative or positive) and this correlation is strong, then B may probably explain (in part or in total) A, or vice versa.
    3. Once you have your correlation, you need to establish whether there is a cause and effect relation between A and B.

    If step 3 does not lead to anything, you are at your own risk to use the result in step 2 to build a trading system. In my view that is what I consider as a gambling trading system. You can win of course, but it is just because you worked things in a way the odds/rewards are in your favor and not because you really have something fundamental behind your trading. If the climate change, your whole gambling system turns the other way, and you become the gambler and your opponent the house while in your head you are still under the illusion that you are the house. So you have to be sure you are always the house in a gambling trading system and also you may also have to deal with the potential moral dilemma that comes with such realization.

    I can go into further in details, but i just wanted to provide a framework with the aim to spark things up and with the hope of getting others to respond and contribute.
  3. Let me rephrase the question:

    Has anyone found that unusual options activity in stocks gives a trader an edge in trading the underlying stocks? If so, please explain.
  4. markg_ny


    Trying to educate myself about the topic I searched “high open interest P/C ratio” (exact quote from your post) on google and this ET thread is second!!!!!!!!.

    After some reading my view is:
    Opening large options position on stock with small options volume has Market Making firm as your counterparty.
    The firm will hedge the position (if puts are involved “the firm” sells the underlying to be some sort of neutral, if calls they buy the underlying).
    Closing options position will result in the firm closing their short or long position.

    So with large open interest (especially for front month, low option volume and low stock volume) any move in the underlying will be magnified since “the firm” to be neutral will buy more stock with move up and sell more with move down (regardless if calls or puts were involved).

    Sample from yesterday:
    ATN (low options and stock volume)
    A large volume of puts early in the morning (2388 puts for Feb strike 20 most of it in the morning).
    There is a ‘significant’ selling (5% drop at around the same time) with a large volume.

    The volume on the stock yesterday was 212,700.
    Yahoo shows (copy from yahoo: Average Volume (3 month): 95,614.3 Average Volume (10 day): 159,944

    Note that most of “Oil and Gas Drilling and Exploration” moved up yesterday (not ATN).

    There are experts on this board so my reasoning could need some corrections.
  5. I would just like to add that when MMs is short put and want to hedge it they can buy a synthetic put (which is buy a call at same strike and short the stock). This makes them neutral, and is also a mechanism that keeps the vols, at a given strike, equal for the put and the call. Do not be surprise if you were to hear some people say "a put is a call and a call is a put".
  6. Thanks for the reply. In your example, if the market maker had to sell puts (assuming retail customer was buying puts), then the MM also would have to sell the underlying stock. So we have an increase in put open interest and also an increase in the short interest of the stock. Sooner or later that stock has to be bought back by the MM.

    So if there is a large open interest in the options for either the calls or the puts, does that show that the sentiment is skewed to the short side (for puts) and to the long side (for calls) so that if the stock gets momentum in the opposite direction of the skew, this will cause a shift in that sentiment and a resulting acceleration of the new trend?
  7. "A put is a call and a call is a put" sounds like the old quote from Roy Neff of Cooper Neff which was a very large options firm who was eventually bought by BNP.

    To address the question:

    Riskfree makes a good point about call put parity in that the puts and calls of the same strike will be priced the same in volatility terms. It’s not likely that a MM will have the chance to buy the call immediately if they've sold the put in that strike but they will have chances to buy other puts (or calls) near that strike. Of course they won’t be worried about a retail customers positions but they surely would at least take note of “firm” positions. Of course these days few MM’s in equity or index options are stand alone guys. What you have is a smaller number of firms making markets in hundreds of books on all 6 exchanges and using centralized risk management in a dispersion matrix. The guys they have on the floor for the most part are just raising their hands for the open outcry trades and managing the systems they all carry on their wireless box. For the most part the days of individual MM who manages his own position in just the books that trade in his pit are gone.

    As far as open interest goes it can be very deceiving. If you see the open interest in the XYZ puts jump by a significant amount one day what do you think you’ve learned? Did the initiator of that trade buy to open or sell to open? Was he buying puts and stock to create a synthetic call which is bullish? Are they part of some time spread and you didn’t notice the back end? Are the linked to a pair’s trade or a dispersion hedge? There is just no way of knowing.
  8. markg_ny


    ATN options and stock relationship is interesting today.

    Sort of showing that options activity can affect underlying movement (most of the time is the other way around)
    The same as last Friday (the volume on Friday increased open interest for Feb. 25 puts):

    Large volume of puts with very sudden stock drop at similar time same time.
    - The options trade is not a part of any spread. (no other activity for ATN).
    - Is someone doing covered put?
    - If someone is shorting stock (sudden drop in price) they are not buying puts for protection (beside covered puts).

    Therefore, by far the best explanation is: MM firm is neutralizing the position.
    We will wait just to see if there is a sudden increase in price when the position is closed (whey MM firm will cover they short.)

    Interesting to see how options affect stock price (for the second time in few days).
  9. gaidaros


    so the edge is finding a way to try rip off the MM, right?
    what is the chance of doing that continuously?
    once the MM notices more and more people take his money
    (let´s suppose it is a single person for ease of discussion)
    he will do something about it to take it back, right?
    i think your model might work at intermediate values but
    not at extreme values, that might indicate reversal

    my 2c, have not tested it

  10. markg_ny


    Since I first mentioned ATN puts 25 for February as a sample last Friday, the open interest increased from 2547 to 14,835 today with 6573 and 5173 traded on 2/5/ and 2/6.

    The point is that since I used ATN to show how options volume affects the underlying price movement (assuming the options are bought, and new contracts were created and MM did some hedging) now it is time to show (hope so) how OI affects the price.
    I could not resist buying 5 $25 Feb. calls for 0.65.
    Closing of the options position will result in massive covering my MM of their shorts.

    BTW: MM is not market-maker person but I believe it is just automated computer program acting as MM for large institution.

    Could be a good question for experts (most will laugh at you):
    Since, options prices are derived from underlying price could it be that underlying price is affected by options?
    #10     Feb 7, 2008