Is the Options Market sending a signal? It always is!

by Wayne Ferbert on February 27th, 2012

One of the things I really like about the options market is the smorgasbord of price data. You get bid/ask, open interest, volume, & last for all of those strike prices for every month of expiration! Compare that to just buying a stock where all you get is one bid/ask, one last price, & one updating volume.

All of this options data provides an opportunity to analyze and over-analyze what the price curves are telling you about the underlying stock or market. It is very tempting to spend a lot of time analyzing this data in detail: graphing it, charting it, etc. All of this data can be It is very easy to over-analyze.

The data definitely signals what the buyers/sellers in the options market think is coming. All of that price data really builds its own supply/demand curve when interpreted together. But don’t forget: you don’t make your money in ANY market because of the signals. Instead, you make your money by selling something for more than you bought it. In fact, the best investments I ever made were when the market signaled one thing – and the actual payoff came when the market moved to the opposite of the signal.

With the caveat on reading too much in to signals firmly in place, the cost of hedging your downside in the broad markets has taken an interesting turn recently. We all know that a primary driver of the cost of any hedge is the time value – a.k.a. the extrinsic value. The further out your expiration for a given strike, the higher the time value cost in the option. That is Options 101.

However, we often look at the cost PER DAY of an option when we look to hedge a position – especially when we use collars. We will often compare the OTM put cost (downside protection) for broad indexes at the identical strike price at the 6-month, 9-month, & 12-month expirations. We divide the cost by the days until expiration to get the cost PER DAY.

Usually, you always get a discount on the PER DAY basis when you go further out on the expiration date. IN other words, the 12-month OTM put option at $X strike is more expensive in total cost than the 6-month OTM put option at $X strike – but it is LESS expensive when calculated on the PER DAY basis. Given that we are long-term investors and have long hold times, we often consider going out to the 9-month or 12-month expirations to save a little bit of money.

The problem we are experiencing more recently: that discount on the PER DAY basis has narrowed. In fact, at some strike prices for S&P500 ETFs where we could reliably find the discount, we can’t find it at all anymore. Even in some of the sector ETFs, we cannot find the per day discount at all.

In a check last week of the SPDR sector ETFs from State Street bank, I could find no discount on a PER DAY basis between the June 2012 and the January 2013 expirations at 10% downside OTM puts for 7 out of 9 of the sectors: the only exceptions being Financials (XLF) and Industrials (XLI). This is very telling data.

But what does it tell us? Did the near-term OTM puts get less expensive on a per day basis? Or did the longer-term options get more expensive on a per day basis? You could argue that you don’t need to quibble about it: on a relative basis, both of those things have happened. But I want to know: is this a signal of some sort?

The OTM puts for the SPY (currently at $136) at $120 strike are effectively the same cost PER DAY for the September expiration as the December expiration – 18 ½ cents per day. But if you look back to November and examine the OTM puts for $16 worth of strikes, there was a 3 cents difference in the cost PER DAY for the June to September expiration.

What has changed since November? Volatility was higher back in November. But probably more importantly, the market has rallied significantly. The SPY is up $20 since November 25th.

So what does all of this data tell us? I am leaning towards the thought that two factors are making the cost per day difference be irrelevant:
  • Volatility has gotten so low that the prices are lower – meaning the difference would be lower on a dollar basis
  • The Markets think the rally overall is likely to continue in the short-term – meaning the near term expirations have gotten cheaper.

I am not sure I would have come to this second conclusion if not for the price data in the nine different SPDR sector ETFs. In the recent rally, the two best performers have been the Financials (XLF) and Industrials (XLI). I am persuaded by t he the fact that these two ETFs still have higher priced short-term options on a PER DAY basis – while the other 7 ETFs do not.

These ETFs have moved the fastest in a short amount of time – meaning the market thinks they have the most risk in re-tracement if the market corrects.

So, overall, I think the options data says the market expects the current up-trend to continue – and the market is priced on that basis. You can certainly play it that way – but don’t ever forget: you will always have the best returns when the market prices are wrong. And when you are on the right side of that wrong price!

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