Optionetics has an interesting article called Using Options to Predict Stock Prices. The author, John Jeffery, writes that, in addition to the usual fundamental analysis and technical analysis methods of 'stock direction prediction', options can help indicate trade direction. Three useful indications include:
- Put/Call Ratio
- Implied Volatility
- Option Volumes
Put/Call Ratios: The most popular Put/Call Ratio is the one used for monitoring the sum total of
option trades at the CBOE (Chicago Board of Trade). The same technique can be used for individual stocks as well.
It is basically the ratio of the number of open call positions relative to the number of open put positions on a
given stock at a given expiry. With experience, it can be used as a bullish/bearish indicator of the underlying stock.
Street Authority has some further information on the
Put/Call Ratio.
Schaeffer's Investment Research
indicates the general market is strongly bullish. They have a series of stock screeners.
Bullish Stock Screeners
- Stocks with a high put/call ratio
- Stocks with high short interest
Bearish Stock Screeners
- Stocks with a low put/call ratio
- Stocks with low short interest
A reference is made to an article by Pan and Poteshman called
The Information of Option Volume for Future Stock Prices where they say that
they "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." You have to read the full
abstract for some caveates though:
We present strong evidence that option trading volume contains information about future stock price movements. Taking advantage of a unique dataset from the Chicago Board Options Exchange, we construct put-call ratios from option volume initiated by buyers to open new positions. On a risk-adjusted basis, stocks with low put-call ratios outperform stocks with high put-call ratios by more than 40 basis points on the next day and more than 1% over the next week. Partitioning our option signals into components that are publicly and non-publicly observable, we find that the economic source of this predictability is non-public information possessed by option traders rather than market inefficiency. We also find greater predictability from option signals for stocks with higher concentrations of informed traders and from option contracts with greater leverage.
One of the authors has another paper entitled
Investor Behavior in the Option Market. One of the interesting points from the abstract
is the remark "none of the investor groups significantly increased their purchases of puts during the bubble period in order to overcome short sales constraints in the stock market." Taken the other way around, puts are an easy method of getting around short selling restrictions on equities.
In visiting a related author, there is a recent paper called
Dynamic Trading with Predictable Returns and Transaction Costs
which discusses some portfolio optimization with a mixture of short, medium, and long term mean reversion based trades. This has nothing
to do with options, but is an interesting article in itself which I wanted to keep.
Implied Volatility: Implied Volatility is the expected volatility of an option's underlying asset up to the option expiry.
This tool can be used for inter-day and intra-day trading calculations. In the article's example, where the underlying is
moving sideways, an increasing Implied Volatility could indicate some major move in the underlying. Various other relationships
can be established as well.
Option Volumes: When looking at option volumes across the whole series of an underlying's strike prices and expires,
look for unusual activity in volume. This means comparing current traded volume with average daily traded volume. It may be possible
to see where traders are seeing resistance or support levels, with the interpretation being whether the volume is in puts or calls.
If there are no related news, earnings events, or government announcements, then someone may know something.