May 18, 2007, Newsletter Issue #67: Open Interest

Tip of the Week

To analyze stocks, we often use option open interest as a means of measuring the relative levels of investor optimism and pessimism. Open interest is the number of outstanding contracts on an option class or series. Open interest will increase by one contract when a buyer enters a new long position while the seller is entering a new short position. Open interest will decrease by one contract if a buyer is closing an old short position and the seller is closing an old long position. And open interest will stay the same if:
>> a buyer is entering a new long position while the seller is simultaneously closing an old one, or,
>> a seller is establishing a new short but the buyer is simultaneously closing an old position.

Put/Call Ratios:
We have found that using option open interest data in the form of put/call ratios is one of the better ways to quantify sentiment. Each stock´s put/call ratio behaves differently and has its own particular timing implications. The analysis can be taken a step further by combining the open interest of all the stocks in a particular industry to form a composite put/call ratio for the sector. We use put/call ratio analysis to gauge whether a stock or sector is poised for a rally based upon large amounts of potential buying strength, or vulnerable to stalling out due to a lack of cash available to push it higher. High put/call ratios are often indicative of excessive pessimism and thus of large amounts of money on the "sidelines." Conversely, low put/call ratios indicate a point at which there is so much optimism that very little money is left to push the stock or index higher.

When gauging sentiment, we´re primarily interested in the convictions displayed by the speculative public. Our research has shown that a contrarian view of public (rather than institutional) sentiment often proves to be a more reliable predictor of market movement. To collect options information that is more likely attributable to these speculators, we focus on the front three months of options data, which is where the small speculators tend to gravitate. By comparing the current put/call open interest ratio to previous readings for that stock, we can accurately gauge relative levels of investor optimism and pessimism. This is extremely important because we have found that the absolute ratio readings can vary substantially from stock to stock. Thus, comparing a stock´s ratio to previous ratios sets up an "apples to apples" comparison that provides a truer picture of relative sentiment.

The manifestation of this analysis is an indicator we call the Schaeffer´s put/call open interest ratio, or SOIR. This indicator represents a ratio of open puts to open calls on only those options due to expire over the following three months. Each daily SOIR reading is then compared to all other readings over the past year to develop a percentile rank. Higher percentiles indicate relatively more pessimism, while lower percentiles suggest optimism. Thus, a rank in the 90th percentile would mean that only 10 percent of all SOIR readings over the past year were higher, or more pessimistic. This suggests a relatively high level of negative sentiment, which can have bullish implications for a stock displaying strong fundamentals and technicals. The opposite argument can be made for a low percentile ranking, which can suggest a stock is potentially overextended and vulnerable to a sell-off due to heightened expectations.

Open Interest Configuration:
Along with put/call ratios, another way to use open interest to analyze sentiment on individual stocks is to examine the "open interest configuration" using front-month option data. The open interest configuration of a stock is simply the number of open puts or calls at the various strike prices and can be illustrated by plotting a chart with adjacent call and put bars representing the open interest at every strike price (Schaeffer´s Daily Sentiment provides current and historical open interest configuration charts for all optionable equities). This approach has proven effective in determining possible resistance and support levels. How?

Option strike prices are usually round-number levels that tend to serve as support or resistance, as buyers view pullbacks to such levels as good entry points for long positions or potential closeout points for short positions. Sellers, on the other hand, look to rallies to round numbers as opportunities to exit long positions or to establish short positions. The fact that there may be significant option open interest at strike prices corresponding to these round number price levels serves to accentuate their significance as support and resistance.

For example, a large amount of call open interest can define a point of extreme market optimism, which usually coincides with the depletion of buying strength. When this strength has been depleted, it takes less selling activity to change the stock´s direction. Also, those who sold these options to speculative investors may buy the underlying stock to balance their bearish positions from selling the options. These long positions will ultimately be sold when the options expire or the call buyers unwind their positions. Moreover, call sellers can become a very significant factor as the options approach expiration, as they generally own stock that they can sell to create overhead resistance.

The opposite would apply to puts. A large amount of put open interest can reflect a level of extreme pessimism toward the stock, which usually coincides with a lack of selling strength. Put sellers may short the stock to balance their bullish position and these shorts must eventually be bought back. Put sellers who do not hedge their positions will try to support the stock as it approaches the strike that they sold to protect themselves from losses.

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