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Every day, multitudes of traders embark upon the task of trying to predict the direction and movement of stocks. Within the analytical tools typically at their disposal, technical analysis and fundamental analysis are considered the most useful; however some traders also look to the options market to try to understand and predict stock price movements. The idea behind this concept is that the leveraged and complex nature of options restricts their use to more sophisticated (institutional) traders and investors, who are better armed at recognising opportunity. Here are some examples of popular indicators that are used.

Put/Call Ratio

The ratio of the number of open calls positions relative to the number of open put positions on a given stock at a given expiry can tell you how many option traders are bullish relative to the number of bears for a certain date. In a joint paper published in the National Bureau of Economic Research, Pan and Poteshman* performed daily cross sectional analysis on 10 years of CBOE data to reveal that doing nothing more than buying stocks with low put/call ratios and selling stocks with high put/call ratios generated a return of 1% per week.

Implied Volatility

IV really refers to the expected volatility of an option's underlying asset up to the option expiry. This information comes from the options pricing model and can be used to determine the percentage movement a stock's price is likely to make. In the example below, the IV from options expiring in 7 to 30 days for MSFT is showing us that the options market is 'pricing in' a possible 38% movement in price over the next year.

Chart 1

click here to enlarge

Although that might not seem like a precise enough figure to trade, it is more noticeable that IV has been increasing since the 6th of August, even though the share price has not moved significantly. The options market is expecting a move in MSFT.

Option Volumes

If you have access to call and put volume data intraday, as you can get from an OX account, look for unusual activity in volume. By comparing the average daily traded volume with the number of calls or puts being placed, you can see where option traders are beginning to set their stalls. Lots of calls is obviously bullish, whereas lots of puts being placed is bearish. Note as well the 'way' in which orders are being placed. Are there huge slabs of contracts going through, indicating program and institutional activity? Just be aware that there is usually a reason why a stock's option trading may be more active on certain days than others. News, earnings and government announcements could all have a natural effect on option volumes and you'll need to filter these out. It's when there is no apparent reason for the big bets to be placed, that should warn you that someone knows something!

One final note of caution when it comes to looking at option trades to help pick stock direction. Please ensure that you look across the whole series of a stock's strike prices and expiries. A huge increase in calls may well be part of a spread trade, a rollover or other multi-legged option strategy.

Stay Sharp,

John Jeffery
Trading Tutors Team

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