Put options are used to hedge against market weakness or bet on a decline. Call options are used to hedge against market strength or bet on an advance. Typically, this indicator is used to gauge market sentiment. Chartists can apply moving averages and other indicators to smooth the data and derive signals.
The CBOE indicators break down the options into three groups: Contrarians turn bearish when too many traders are bullish. Contrarians turn bullish when too many traders are bearish. Traders buy puts as insurance against a market decline or as a directional bet.
While calls are not used so much for insurance purposes, they are bought as a directional bet on rising prices. Put volume increases when the expectations for a decline increase. Conversely, call volume increases when the expectations for an advance increase.
These extremes are not fixed and can change over time. In contrarian terms, excessive bullishness would argue for caution and the possibility of a stock market decline. Excessive bearishness would argue for optimism and the possibility of a bullish reversal. When using the CBOE based indicators, chartists must choose between equity, index or total option volume.
In general, index options are associated with professional traders and equity options are associated with non-professional traders. Even though professionals use index options for hedging or directional bets, puts garner a significant portion of total volume for hedging purposes.
Notice that this ratio is consistently above 1 and the day SMA is at 1. This bias is because index options puts are used to hedge against a market decline. Notice that the day moving average is at. Non-professional traders are more bullish oriented and this keeps call volume relatively high. The put bias in index options is offset by the call bias in equity options. The day moving average is still below 1. However, the indicator does fluctuate above and below 1, which shows a shifting bias from put volume to call volume.
Not because it is necessarily better, but because it represents a good aggregate. Chartists should look at all three to compare the varying degrees of bullishness and bearishness. A spike extreme occurs when the indicator spikes above or below a certain threshold. The chart below shows the indicator with horizontal lines at 1. A spike above 1. As a contrarian indicator, excessive bearishness is viewed as bullish. Too many traders are bearish.
Extremes in May and June resulted in shallow bounces or flat trading before the market continued lower. The indicator then spiked above 1. Calls are bought when participants expect the market to rise. Excessive call volume signals excessive bullishness that can foreshadow a bearish stock market reversal.
The October signal worked out well, the December signal was too early and the April signal worked out well. The chart below shows the indicator as a day SMA pink. See the SharpCharts section below for ways to make a plot invisible. There are a few takeaways from this chart. First, notice that the indicator is much smoother with less volatility. Second, the day SMA can actually trend in one direction for a few weeks.
Third, the spike thresholds are set lower because of less volatility. Fourth, the day SMA slows the indicator to produce a lag in the signals. A bullish signal occurs when the indicator moves above the bearish extreme. A bearish signal occurs when the indicator moves below the bullish extreme. Because this moving average can trend for extended periods, it is important to wait for confirmation with a move back above or below the threshold.
Waiting for this confirmation would have prevented a long position when the indicator moved above. Notice how the indicator kept on moving higher and remained at relatively high levels for an extended period of time. A blue horizontal line is set at 1.
This coincided with a flat market in the first half of and then an extended decline. The relatively elevated levels indicate a bias towards put volume downside protection or direction bet. The moving averages stayed in this range until April and then both shot above 1. Call volume increases as a rally takes hold, while put volume increases during an extended decline. These contrarian signals can sometimes pick tops and bottoms, but sometimes they will be too early or simply wrong.
Indicators are not perfect. It is important to identify the extremes and wait for an extreme to be reached.
Waiting for a little confirmation can often filter out bad signals. This will expand the price scale to fit with the smoothed version day SMA. These chart settings are shown below the chart. Click here for a live example. Larry McMillan is virtually synonymous with options. Now, in a revised and Second Edition, this indispensable guide to the world of options addresses a myriad of new techniques and methods needed for profiting consistently in today's fast-paced investment arena.
Log In Sign Up Help. The calculation is straightforward and simple.More...