What options trades say about your stock

Pin risk, collars, the VIXX volatility measurement, delta hedges, put/call ratios, triple-witching, baskets, swaps and the greeks (the symbols, not the people) – all terms familiar to options traders and Greek to most IROs – were the topic of an instructive panel at the NIRI annual conference in San Diego.

Moderated by Elizabeth Higashi, principal at Sard Verbinnen & Co, the panel entitled ‘Short selling: options and derivatives’ included Ryan Danielson from the corporate advisory services division at Thomson Reuters; Marty Kearney, director at the Chicago Board Options Exchange; and Jonathan Simon, managing director of US equity derivatives at Citigroup. In addition to arcane jargon and options trading strategies, attendees received a ‘secret decoder ring’ of sorts to help IROs understand what options trading says about how the market views a stock. As one panelist put it: ‘There is information in every trade.’

The options lowdown
Here is a snapshot from those panelists of what IROs need to know. First – and no surprise here – as the markets have grown more volatile, options trading has exploded: trading volume in the US was up 13.44 percent, year to date, and a whopping 38 percent for the month of May, year-on-year.

Options allow investors to express an opinion about a current stock price. They come in two flavors: puts and calls. Puts give a holder the right, but not the obligation, to sell a security at a given price by a certain date. Calls give a holder the right, but not the obligation, to buy a security at a given price by a set date. And all options settle after the close of trading on the third Friday of every month. One option contract controls 100 shares of the underlying security, so a quoted option price of $1 will cost the buyer $100.

Hedge funds, with the fewest restrictions, are the most active players in options – but don’t assume they are the only ones trading. Many mutual funds, and to a lesser extent other institutional investors, use options to gain exposure to a position; they’re just not as active as hedge funds, nor do they use the newer and more exotic derivatives constantly being created by bank trading desks.

A massive 80 percent of the trades and 60 percent of the dollar value in options for US-listed securities are exchange-traded options, which translates into greater transparency of price and volume – for which read information. Count yourself fortunate if you are the IRO of a US-listed company, compared with options on stocks listed elsewhere, which typically trade over the counter in much more opaque markets.

Trading points
With 2,800 optionable securities listed in the US and an average of 100 separate options per security (puts and calls at different strike prices and expiration dates), there are an estimated 280,000 separate tradable options available on listed securities in the US alone.

Obviously, there is not a great deal of trading on many of those options, so pay attention to the options that trade in volume.
While there is no shortage of information embedded in options markets, it’s not necessarily factual or true, and there are many reasons a trader or investor will enter an options trade.

• Options can be used to obtain exposure to a single security – or a basket of securities – at an overall lower carrying cost than can be had by buying the underlying stock.

• Embedded in options are the market’s expectations about future earnings, dividends, the stock price, upcoming new product announcements and M&A activity – any future development that might change the price of the underlying stock.

• Options activity on your stock may have very little to do with your company but, rather, may be a hedge offsetting an opposite position in a peer company, a bet on macroeconomic moves your company gets swept up in, or a sector bet on your industry.

• Options trading in the days leading up to earnings announcements will give you a view of where the market is betting the stock will go. If you have relatively even interest in puts and calls near your current stock price, the market is not expecting any surprises from you. If you’ve got heavy call volume outstanding with few puts, traders are betting on an upside surprise; if it’s weighted to puts, the betting is that you’re going to disappoint. Check also whether the options activity in your stock differs from that of your peers.

• The savvy IRO should monitor options activity if you’ve got big news pending, even if your stock isn’t moving. Unusual options trading can indicate to an IRO that inside information is leaking.

• Remember that all options expire on the third Friday of the month. You may see heavy volume in your stock, particularly if your stock is in an index, as the markets settle out the following Monday.

• Triple-witching occurs the third Friday of March, June, September and December when stock options, stock index futures and stock index options all expire on the same day. If options on your stock trade in those months, hang on for a wild ride.

• The more volatile the stock, the more options trading you’ll see. For a quick snapshot of what the market thinks the volatility of your stock is, go to www.ivolatility.com. If you are interested in calculating pin risk, figuring out the delta swaps, devising collar strategies, or just learning more, please see www.cboe.com or www.optionseducation.org.