Option Market – Outlook/Review for the week ending July 16, 2010
Published: 7/16/2010 3:40:15 PM by Randy Frederick

Tip of the week
Whether you're buying or selling an option, the type of order you place can have a significant impact on the time, price or manner in which your order is executed. While many market factors are beyond your control, if you have a clear understanding of how the order you place will be received in the options marketplace, you will be much less likely to be surprised by the outcome.

Let’s begin with the different Time in force characteristics of an order. When you enter a Day Only (DAY) order for an option, it is good only for the current regular trading session. There are no pre-market or post-market sessions for options like there are for many stocks and ETFs.

The regular trading session for all narrow-based index options and all equity options is from 9:30 AM until 4:00 PM Eastern Time (ET). Other option products may have slightly different trading hours as follows:

Good until cancelled (GTC) orders remain active for 60 calendar days at Schwab. Like DAY orders, GTC orders apply only to the regular trading session for the particular option product as described above.

Market orders must be entered as DAY orders only on all option exchanges. Simple limit orders on single-leg strategies can be entered as DAY or GTC on all option exchanges. However, GTC may not be available on other order types on some exchanges. Additionally certain order types and orders with specific qualifiers may not be available on all option exchanges. I’ll be discussing all of this in more detail in the next few weeks.

After an impressive bounce off the 7/2 lows, the market has flattened back out at about the midpoint of the last two months’ range. While earnings season has thus far been met with more positive surprises than negative ones, economic reports as of late have been somewhat less encouraging. With a mixed bag of indicators and the peak of earnings reports still ahead, a clear picture of the near-term market remains elusive.

Option Volumes
While volumes usually lag market trends by at least a few weeks, the range-bound market of the past 2 months has finally begun to take its toll. July volume currently stands at 13.9M; slightly below June’s already light volume of only 14.1M and well below the YTD average which now stands at 16.0M contracts per day. Since the 2010 rally pretty much ran out of steam in early May, this is pretty much what you would expect. While volumes tend to taper off a bit in the summer anyway, the two events occurring concurrently have exacerbated the seasonal trend.

Open Interest

OI Change
There was a slightly larger than average increase in the Index OI Change for puts on Tuesday, followed by a slightly larger than average increase (of equal size) in calls on Wednesday. Since these two pretty much offset each other and given that it is expiration week, a time when many positions are rolled out to subsequent months, these moves were not big enough to provide any insight. This indicator remains neutral in the short-term.

Despite it being expiration week, the Equity OI Change was more flat and balanced than you would typically expect. I think this speaks a bit to the significant directional uncertainty that exists at the moment. It is therefore also neutral in the near-term.

OI Participation
Much in the same way as we see summer volumes tapering off, the slowly rising trend of the Index OI Part has also leveled off in Q3. As a result, it remains neutral in both the short-term and the long-term.

In a very similar fashion the Equity OI Part has also pretty much flattened out and remains neutral in the near term while remaining just slightly bullish in the long-term. Barring a major surge in the market, I suspect I’ll be moving the longer-term trend to neutral also, in the next week or two.

Since Open Interest Participation is one of the more lagging indicators discussed in this blog, it will often move the same direction as volumes, but it tends to do so in large steps at each expiration.

Open Interest Put/Call Ratios
The VIX OIPCR has ticked up a little and is now at .85 versus .81 at this time last week. So while institutions are holding (long or short) 85 puts for every 100 calls on the VIX, the fact that it has increased a little this week is actually a slightly bullish reading, since a higher level indicates more downward pressure on the VIX. This indicator is therefore slightly bullish for the market in the near-term, but it remains neutral in the long-term.

Remember, since July has 5 Fridays, July VIX options expire next Wednesday (7/21), so we may get better insights from the VIX next week.

Meanwhile the SPX OIPCR which was at 1.52 at this time last week, continues drifting lower and is now at only 1.49; the lowest reading since mid-December. Since this ratio usually rises with the market this decrease would be a slightly bearish signal in the short-term. Since it has been declining for more than a month now, it is also enough to move it to slightly bearish in the long-term.

The Index OIPCR has changed very little since last week and now stands at 1.29 vs. 1.28. Since this is such a small move it is neutral in the short-term. The longer-term trend also remains neutral.

The Equity OIPCR also remains flat at .88 this week. Being unchanged puts it back to neutral in the short-term and it remains neutral for the long-term.

Volume Put/Call Ratios
The Index VPCR continues to be all over the map, though the near-term direction has been slightly more down than up. As a result, we’ll read it as slightly bearish in the short-term. The current 5-day ratio is 1.40 compared to 1.39 at this time last week; a very minor move. It
therefore remains neutral in the long-term.

The most recent trend of the Equity VPCR, which started on 7/8 has been almost exactly sideways with the 5-day average .59; the exact same level as this time last week. It is therefore neutral in the short-term and it remains neutral in the long-term.

As I mentioned last week, since the June expiration the ISEE has spent the majority of its time close to or below 100, and it remains in this zone again this week. Since it has been virtually flat the past few days, the short-term view is neutral at the moment and the long-term sentiment remains neutral.

The 30-day historical volatility of the VIX continues to slide and now stands at 111% compared to 136% at this time last week. While the VIX has a tendency to over-react to the upside, it often takes awhile to come back down. However, since the beginning of July, the VIX has dropped rather sharply, which may very well be setting itself up for another sharp spike higher the next time the market sells off. For option traders, volatile volatility can sometimes present opportunities.

Since we are now in earnings season, volatility is likely to be higher during the first and last hour of the trading session, as most companies like to announce just before the market opens and just after it closes. If you are using option strategies that benefit from rising volatility, you should consider entering those positions during the middle of the day. If your strategies benefit from falling volatility, all other things being equal, entering those near the open and the close should theoretically help them perform slightly better overall.

While it had been falling almost daily for nearly 2 weeks, the VIX began creeping higher this week in response to earnings season anxiety.
Since a rising VIX is generally a bearish sign for the market, this is a slightly bearish indication for the SPX in the near-term. The longerterm trend remains neutral at this time.

As of this writing the VIX IV Gap stands at +87; slightly lower than the +96 reading at this time last week, but quite a bit lower than the +150 reading just a couple of days ago. This means that calls are still more expensive than puts, but if the current rising VIX trend continues, this gap will likely narrow substantially in the coming days. This indicator remains slightly bearish for the market in the near-term but is still neutral in the long-term.

As I’m writing this (mid-day Friday 7/16) the Jul VIX futures (which expire on 7/21) were trading around 28.6%; just slightly above the spot VIX level of 27.7. This of course means the futures believe the VIX is just slightly underpriced at the moment and since these futures expire in a few days, we could see slightly higher volatility early next week. Remember, the spot quote and the futures quote have to converge at expiration. The longer-term futures are higher still in the range of 30.5% - 33.6% over the next 4 months. These indicators therefore remain slightly bearish in the near-term and bearish in the long-term for the SPX.

As I’m writing this (mid-day Friday 7/16) the SPX is at 1071 and down more than 2%. While some profit taking after a 7-day rally can be expected, it is rather unusual for the market to be so weak on expiration Friday. This week, with only a couple of exceptions, the majority of the option indicators either stayed the same or moved in a bearish direction.

With the exception of May, most of the months this year have been strong going into expiration and weak coming out of it. With earnings season well underway, expiration past, and a slightly bearish group of indicators overall, I do think next week warrants considerable caution. As earnings season almost always brings higher than normal volatility, some of which we’ve already begun to see, I expect continued volatility and relatively large swings on a day to day basis as more of the industry bellwethers announce their Q2 results.

Longer-term, Q3 overall will likely continue to be challenging and choppy, so if you’re going to be in this market, pick up your positions in small lots on down days, and be very judicious using leverage.

Bottom Line
Below is a table that summarizes my observations, based on the details above.

Composite Market Sentiment

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab.

Multiple leg options strategies will involve multiple commissions. With long options investors may lose 100% of funds invested. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options."

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered.

Please contact a tax advisor for the tax implications involved in these strategies. Past performance should not be construed as indicative of future results.

Please note that this content was created as of the specific date indicated and reflects the author’s views as of that date. It will be kept solely for historical purposes, and the author's opinions may change, without notice, in reaction to shifting economic, business, and other conditions.

The information presented does not consider your particular investment objectives or financial situation, and does not make personalized recommendations. Any opinions expressed herein are subject to change without notice.

Supporting documentation for any claims or statistical information is available upon request.