Option Trading and Sentiment
Traditionally, odd lot statistics were reliable indicators of the sentiment of uninformed, small investors. That small investors, who did not have enough capital to purchase round, 100-share lots, traditionally called odd lots, were heavily buying stocks was an indication that the uninformed public was overly optimistic. When small, uninformed investors were highly pessimistic, they would short sell odd lots. The odd lot figures represented a measure of uninformed, public speculation, which tended to be highest at market turning points.
Today, listed options data has replaced the old odd-lot figures as one of the best measures of public speculation. A call option is an option to buy an asset, usually a stock or commodity, at a fixed price for a specific period. A put option is an option to sell an asset at a fixed price for a specific period of time. Some options, by expanding on the basics of time and price, can become complex. However, the standard call and put option is the most widely traded and has the highest volume of any option type. The option market, by its very nature, is speculative. It depends on leverage for maximum gains, and positions can close worthless on the expiration of options. As such, it has become a speculative vehicle for the uninformed public.
Let us look at how the options market can measure sentiment. Let us assume that Jerry thinks that the price of stock XYZ will increase above its current level of $20 per share. Jerry can purchase a call option in which he has the option to buy 100 shares of XYZ at a price of $20 per share anytime in the next three months. The option price and premium—say, $2 per share—is much less than the outright purchase price of the stock. If the price of XYZ rises above $20, Jerry can exercise his option and purchase shares at the guaranteed, and now favorable, $20. If, instead, the price of XYZ declines or remains flat during the three-month period, Jerry will allow the option to expire and he will lose his investment. Thus, the option market gives Jerry, an uninformed player, a way to speculate about the movement of the price of a stock by paying a small fee for the option. When investors think that stock prices will rise, they speculate by purchasing call options. When investors are bearish, they speculate by purchasing put options. When investors are very bullish, they buy out-of-the-money call options—those that have a striking price above the current stock price because they trade at very low prices.
Owners will exercise or sell their call options when they correctly project price increases and their put options when they correctly anticipate price decreases. When investors incorrectly predict market moves, exercising their options is unprofitable. If the owner of an option does not exercise the option by the expiration date, then the option expires worthless.1
1. It has long been thought that most options expire worthless, indicating that most people purchasing options have incorrectly predicted the direction of market moves. However, recent research indicates that more are exercised than had been thought. In the November 2004 issue of Technical Analysis of Stocks and Commodities, Tom Gentile reports on a study of 30 years of option data conducted by Alex Johnson of the International Securities Exchange who found that only 30% of options expire worthless. Roughly 10% are exercised, and the remaining 60% are closed through offsetting transactions. The percentage expiring worthless, nevertheless, is large and still suggests that many option buyers are uninformed.
Because the purchase of a call represents one who believes the stock market will rise and a put reflects a bearish opinion, a ratio of calls to puts or puts to calls represents the relative demand for options by speculators and, thus, is a hint as to their disposition toward the market. The more call buyers relative to put buyers, the more optimistic are the speculators.
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