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Summary - Options trading allows investors to quickly profit from a trade without having to own the underlying stock or asset. Three of the most important factors that go into successful options trading are strike price, volume and time. A change in one of these factors will typically affect the other two.
For example, if an options contract has a long time until expiration the strike price may be far apart from the current price of the asset and the volume will probably be light since investors may choose to wait for further clarity on price direction. However, if the expiration date falls near an event such as an earnings call, it is possible to see the volume (i.e. buying and selling) of the options increase. This is because earnings announcements can cause the price movement in stock prices that is needed to put an option “in the money”.
Two of the most common standardized options contracts are puts and calls.
- A call option is a buying action initiated by an investor who is looking to purchase a call option. This makes the prospective buyer the owner of the option. A call option is purchased due to speculation that the underlying stock price is going to rise above the strike price.
- A put option is a selling action initiated by an investor who is looking to sell a put option. This makes the prospective seller the owner of the option. A put option is purchased due to speculation that the underlying stock price is going to fall below the strike price.
For an investor, the lack of a buying or selling obligation is the difference between futures and options contracts. Futures contracts have a strike price and an expiration date, but in the case of trading futures, the contract must be executed.
At any moment in the market, investors are speculating that their position on an asset’s price movement is the correct one. Hedge funds and institutional investors are frequently the owners (or issuers) of options. They may post several puts and calls within a different trading range to facilitate orderly buying and selling. And, since not every option will expire “in the money” it is an opportunity to profit since the owner of the option receives a premium for selling the option.
When put option volume is strong it is a bearish signal because there is a strong belief that the price is going down. On the other hand, when put option volume is weak, it is a bullish sign because it means that there is a belief that the underlying asset will be increasing in value.
Introduction
Options trading is based on speculation. A trader will try to find an options contract that supports their perception of where a particular stock is headed. When they are bullish about the stock's performance, they may look to purchase a call option. This gives them the right, but not the obligation to purchase a fixed amount of shares at the strike price of the contract up to the contract's expiration date.
This article is focused on another common option contract called a put option. With a put option, the buyer of the contract acquires the right, but like a call option, not the obligation, to sell a fixed amount of shares at the strike price of the contact up to the contract's expiration date.
At any given time, there may be dozens of call options or put options for stock. These contracts will have different strike prices and expiration dates that help to facilitate orderly trading. Options traders will look at not only the strike price but also the contract’s trading volume to decide whether or not to enter the trade.
In this article, we'll take a closer look at the put option volume. We'll define what it is and why it's important. For those of you that are new to options trading, the article will also help you become familiar with key terms regarding put options. We'll also review the theory behind using options volume to guide trading and discuss if it really works.
What is put option volume?
Put option volume means the amount of buying or selling for a particular contract. It is usually similar to the volume of the underlying asset. However, the volume is indifferent to the price direction of a stock. Volume only indicates to investors how actively an options contract is being traded. It is up to the investor to speculate on the price direction.
One way they can do this is to look at the put/call ratio. This indicates how many put options are being traded relative to call options as a percentage. When the put-to-call ratio is high it means that more put options are being traded relative to calls and signals that investor sentiment towards that stock is bearish. Conversely, when the put-to-call ratio is low it means that more call options are being traded relative to puts and signals that investor sentiment is bullish. Put volume is specific to an options contract and not an indicator of what is going on in the broader stock market. Put volume can be high in both a bull market and a bear market.
Key terms related to put options
Strike price – this is the minimum price that the stock has to fall to for a buyer to consider picking up the option they purchased. The strike price for a put option is usually lower than the price at which the stock is currently trading. So for example, if an investor wants to buy a put option on AT&T stock that is trading at $31 per share, they may look for a put option with a strike price of $29. If AT&T’s stock falls to that level, the put option allows them to sell the shares at $27 (this is called putting the option on the buyer). Since an options contract on a stock is equal to 100 shares, this would leave the trader with a $200 profit ($2 x 100). However, their actual profit will depend on the premium they had to pay for the option (see below).
Expiration date– this refers to the last date the option can be left open. On or before this date, the buyer of the option must exercise the option otherwise it is allowed to expire. The expiration date is fixed as the 3rdFriday in the month that the option is expiring. The seller of the put option is speculating that the contract will expire worthless, allowing them to collect the premium without having to buy shares.
Premium – this is the cost of the options contract (in this case a put option) to the buyer. Think of it as a transaction fee. The price of the premium is set based on the value of the underlying stock. As the stock price moves closer to being in the money, the premium goes up. The important thing to remember about a premium is that for the buyer of the option, this is the only capital that they are truly putting at risk in the event they decide not to exercise the option. If using the example of AT&T stock, the premium for the put option was $1 it would cost the buyer $100 to purchase the option. Whether or not the buyer chooses to exercise the option the seller would collect the $100. However, if the buyer does exercise the option than the $100 has to be taken into account when considering how much profit the trader made. In our example, the trader made $200 from the difference in the stock price, but that cost would be reduced by $100 because of the premium.
In the money – a term used to describe a put option that would be worth more than $0 if sold on the open market. In our AT&T example, if the stock was purchased with a strike price of $29, the trade would be considered “in the money” as soon as the price fell to $28.99
At the money– a term used to describe a put option where the market price of the stock is the same as the strike price. In our example, that would mean the stock price was at $29.
Out of the money– this is a term that describes a put option where the market price of the stock rose above the strike price. In our example, this would mean that after purchasing the put option, the share price of AT&T stayed above $29. The buyer of the put option would simply allow the contract to expire "worthless" and they would only lose the premium that they paid for the call option. Call options that are out of the money are referred to as "OTM call options".
Bid-Ask Spread– this refers to the difference, expressed as a percentage, between the highest purchase price being offered for a security and the lowest offered sales price for the same security. A wide bid-ask spread usually indicates a lower volume while a narrow spread usually indicates high volume. This is because as the bid/ask spread becomes narrower, the put option will be closer to being “in the money” and therefore more desirable.
Implied volatility and put option volume
Implied volatility is the expected volatility of the underlying asset contained within the put option. Implied volatility affects the premium that the seller of the option is paid. When there is high put option volume, there is an expectation that the price of the asset will decline. This increases the level of implied volatility as the market expects that more traders will seek to buy the options. Since the market is continuously adjusting the premium that a buyer will have to pay for the option, a high level of implied volatility increases the premium for the option. Implied volatility will decrease when demand for a put option is low. In response, the premium for the option will also decrease.
Implied volatility can be higher or lower depending on the option’s expiration date. For options with short-term expiration dates, the option will be less sensitive to implied volatility. However, longer-dated options are more sensitive to implied volatility because traders know there is a greater likelihood that the option will become “in the money”.
How to track put option volume
Two of the largest options exchanges in the country are both located in Chicago, Illinois. The first is the Chicago Board Options Exchange and the other is known as the Options Clearing Corporation. Both exchanges handle equity options as well as futures contracts.
Option activity is displayed in the form of an options chain on the trading platforms of most online brokers and stock traders. An options chain displays the strike price, the last price of the option, the current bid and ask price, the percentage of price change, the volume of trades made and the open interest (i.e. the number of open contracts for that strike price and date).
Do call option volumes accurately predict stock price movement?
The answer is sometimes, but certainly not always. Trading options based on volume assumes that the trading activity is being done by informed stock traders. It is risk neutral and can be highly competitive. A lot of options trading is done by hedge funds and other institutional investors. Buying or selling a put option is based on their fundamental and technical analysis regarding the price direction of the stock.
If the trader is anticipating good news about a stock, such as an earnings report that is expected to beat analysts’ expectations, then they will look to sell put options. Since the trader is anticipating that the share price will be increasing, they are hoping to find buyers that have a different opinion of the stock who will pay them a premium to buy their put option.
On the other hand, if the trader is anticipating bad news about a stock, they will look to buy put options to capitalize on the price movement.
In this way, options volume complements other trading signals. If there is a high put volume that is accompanied by a rising price for that put option it is a good sign that there is bearish sentiment surrounding the underlying asset. If there is high put volume that is accompanied by a declining put option price, it is a signal that there is speculation that the underlying asset will be increasing in price.
Some investors will look at technical indicators to help assign a context to a put option that has high volume. For example, if an option’s daily volume is breaking out of its moving average for a defined period of time (20-day, 50-day, 200-day, etc.) then that may indicate that the stock price is ready to make a big move in the trending direction.
The final word on put option volume
Put options are a selling action based on speculation that the price of the underlying asset is going to decline. Like any investment strategy, price movement is only one factor for investors to consider when deciding whether to enter a specific options trade. The time to expiration and put option volume are also important.
Put option volume measures the amount of buying or selling for a particular put option. On any given trading day, there can be multiple puts and calls available for a stock. The ones that are trading most actively are the ones that can give traders both the price movement and volatility that they need to enter and exit option trades. When the put option volume is high, it means that traders are expecting price movement that will put the put option “in the money”. In contrast, when put option volume is light, it may mean the asset is not expected to move much in price. The put option volume along with other factors like implied volatility factor into the premium that a buyer pays to purchase a put option.
