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Posts Tagged ‘put/call ratio’

What Option Open Interest Means to the Trader

Option open interest is the number of options contracts open in a specific option series.  Open interest serves as a measure of option liquidity in the underlying option series.  The higher the open interest, the tighter the bid/ask spreads will be so slippage in trades will be lower.  When looking at option series, you want to be sure open interest is at least 5,000 and that the bid/ask spreads are no larger than 20 point apart.

When net buying or selling occurs in the underlying security, the open interest will show this change in the same direction of trader moves.  Increases in call open interest indicate the underlying is advancing up while increases in put open interest indicate more selling pressure.

Here are some rules on how to interpret open interest levels for OTM calls and puts in relation to the stock’s price movement:

  • Growing OI in Calls – confirms strength of stock’s advance
  • Declining OI in Calls – bearish divergence of stock’s advance
  • Flat OI in Calls – slightly bearish as no additional support for stock advance
  • Growing OI in Puts – confirmation of stock’s decline
  • Declining OI in Puts – slightly bullish as no additional support for stock decline
  • Flat OI in Puts – slightly bullish as it is not confirming decline

The growing interest in OTM and ATM options will confirm the stocks continued movement in the same direction.  Basically, this means the traders who have
been right are still buying more options for continuing the same direction.  In comparison, when open interest falls it indicates that traders are leaving the trade so it will likely end the current movement.  Traders are taking their money off the table.

The chart below displays a put/call open interest chart for Salesforce.com (CRM).  Notice how the blue line has been declining from 1.25 down to 0.95.  This indicates the number of puts are declining while the calls are increasing.  The traders are starting to turn more bullish on CRM as its stock price (red line) has increased to $125.

Put/Call open interest chart for CRM - getrichinvestments.com

Click to enlarge

Option Selection for Covered Call Writing

Throughout the day, a person makes hundreds of decisions.  Paper or plastic? Double cheeseburger or salad?  Home brewed coffee or Starbucks Brew to Order?  And for option traders, which option to select from a large list of strike prices and expiration dates.

Option selection can be difficult especially for the new option investor.  Do you play a short-term or long-term option?  Do you take risk with OTM options or play it safe with DITM options?  Don’t let the selection process get too complicated for you.  Follow these three questions when making an option selection:

  1. What direction will the underlying stock go in the future?
  2. What are your expectations for the stock?
  3. What is your risk tolerance?

For the first question, don’t just guess where you think the stock will go in the next few months.  Look at the put/call ratio on the open interest tables.  Are there more calls than puts?  This indicates that investors feel the stock will rise.  If there are more puts than calls, then investors feel that the stock is going to decline.  You can use the put/call ratio to help determine the future direction of the stock.

The risk is in selecting the strike price of the option.  You have three choices: ITM, ATM and OTM.  Which one works for your stock?  An ITM has the highest price as it has intrinsic value because the stock price is higher than the option strike price.  This intrinsic value provides a spread for the option, making it less risky.   An ATM is when the stock price and option strike price are very close.  Generally, the price of the option is all time value and it has more premium than an OTM option.  This is the middle ground on the option risk scale.  The OTM option is the riskiest option play.  The option writer gets less premium income and takes on the risk that the stock will move higher to get a better return.  However, when the stock price does rise, OTM options have the greatest return.  You probably have heard about the more risk, higher return trade.

Now, you need to select what time to sell?  The more time the more premium income.  Selecting the right time to sell is up to the option trader.  Regular options are up to nine months and LEAPS are for up to 2 years.  You must decide how much premium you want to receive based on how long you want the trade to be.  For covered calls, most writers select the monthly option and repeat until called away.  However, this should be based on the objective of the covered call writer.

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