Gauging Stock Sentiment with Options

Even for those who aren't interested in trading options, options data can provide information that can possibly help inform their strategy. With options data, traders can get a broader sense of a stock's market sentiment that can potentially provide insights of what other traders are doing with the stock's options. Here are three options metrics that can help a stock trader gauge sentiment in the market:

1. Open interest

2. Put/call ratio

3. Sizzle Index

This data often delivers market clues on sentiment and can potentially indicate where a stock is heading, providing a trader with information about when a trend might be forming, continuing, or ending.

Open interest is best defined by how it's calculated. When an exchange creates a new options series, the open interest is zero before trading begins. Every trade is either opening, where a trader establishes a new position, or closing, where a trader exits an existing position. A buy might be opening or closing, and a sell might be opening or closing. Whether a stock trader buys or sells an option first, both are considered opening trades. For every options position created through an opening trade, open interest goes up by one. For every position closed, open interest goes down by one. As a result, open interest is the number of options in traders' positions not yet closed, whether those positions are considered long or short.

As demonstrated in the image above, a trader can find the open interest for an option on the Trade tab of the thinkorswim^® platform by following these steps:

1. Enter a symbol in symbol box.

2. Select Volume, Open Interest in the Layout drop-down list of the Option Chain section.

3. Open interest now appears in the Option Chain columns for both calls and puts.

Some traders and investors look at the strike price of an option with the highest open interest and interpret that as a potential stock-price target. The highest open interest strike price might also be seen as a support or resistance level for the underlying stock depending on the option type.

According to the theory of "max pain," traders typically buy calls and puts, either as a directional opinion on a stock (call) or as a potential hedge (put). If the stock price is away from the strike price, either the calls or puts at that strike will be considered in the money (ITM).¹ However, if the call is ITM, the put at that strike is considered out of the money (OTM)² and vice versa. Whoever bought that OTM option could potentially be losing money.

When the stock is exactly at the strike price at expiration, both the calls and puts at that strike are considered nearly worthless. A trader who bought either call or put could be losing money. That's the "pain." The "max" part comes from the strike price that has the highest open interest. The highest open interest strike price is where the largest open long options positions are. If the underlying stock price reaches that strike, it could cause the greatest number of traders who are long those options to experience a loss.

Evaluating the validity of the "max pain" theory is difficult, but it's one way traders can potentially gauge sentiment. While using open interest can be potentially useful, a trader might not want to base stock price targets solely on strikes with the highest open interest. There might be other indicators to use in addition to open interest.

One type of put/call ratio measures the trading volume in a stock's puts and calls. If 100 puts have traded, and 100 calls have traded, the put/call ratio is 1.00. If 200 puts have traded, and 100 calls have traded, the put/call ratio is 2.00. The P/C ratio is usually considered a contrarian metric. Some traders think it's a signal for a potential stock reversal.

For example, calls might be bought after a stock has risen in price, and puts might be bought after the stock's price has dropped. Some readings of investing theory suggest some stock traders might get caught up in the excitement of a big move up or down and expect it to continue. They place bearish long put trades after the stock drops and bullish long call trades after a rally. The P/C ratio is a measure of the amount of put activity relative to call activity in the options market.

When the P/C ratio is low, it potentially indicates more people are trading calls, which can mean retail investors are buying. That can potentially signal a top in the stock price, with veteran traders taking profits as retail traders buy, which might potentially lead to lower stock prices.

When the P/C ratio is high, it might indicate more people are trading puts, which can suggest retail investors are buying them as a hedge or speculation that the stock will likely continue to drop. The high P/C ratio might also suggest a stock bottom could be in place, when more experienced traders who have shorted the stock are taking profits by buying back their stocks at lower prices. In theory, veteran traders are buying short stock back from less-experienced traders who might be exiting their long stock positions by being stopped out or having to close positions to meet margin calls. This activity mighty drive stock prices higher. As a result, low P/C ratios are often seen as potential reversals after a stock rally, while high P/C ratios are seen as potential reversals after a stock drop.

Traders can find the P/C ratio on the Trade tab of thinkorswim (see image below). It's located in the Today's Options Statistics section below the Option Chain. The P/C ratio is located on the right side of the screen with other statistics.

Many followers of P/C ratios assume that buying into strength or selling into weakness leads to losses. However, this assumption isn't true for all traders in all stocks during every rally or drop. As a result, some traders might decide to use the P/C ratio cautiously in conjunction with other directional indicators. An extreme level of the P/C ratio can reinforce a bullish or bearish bias and can potentially assist a trader as they time a trade entry or exit.

For example, a trader who is long on a particular stock might look to take profits when the P/C ratio is high after the stock has rallied. When using this approach, it can be beneficial to remember that what's considered a high or low P/C ratio depends on the characteristics of the asset. For example, the P/C ratio for an index like the S&P 500^® index (SPX) or Nasdaq-100^® (NDX) is usually above 1.00 because a lot of institutions regularly buy puts as hedges for their portfolios. Stocks that are subject to a high number of price swings might have P/C ratios between 1.2 and 0.80 as trading activity shifts from calls to puts and vice versa. Before using P/C ratios to help shape trading decisions, it's important to understand when the ratio for certain assets is considered high or low.

The third metric—the Sizzle Index—is a number exclusive to the thinkorswim platform. It's the ratio between total options volume on a given day to the average total daily options volume for the previous five trading days. It measures whether options trading has been more or less active relative to the five days prior. If the Sizzle Index is greater than 1.00, it usually indicates that options volume is greater than the average of the previous five days. If it's lower than 1.00, the present day's volume is considered lower relative to the average of the previous five days.

The Sizzle Index is found on the Trade tab under the Today's Options Statistics section. There are multiple Sizzle Indexes:

• Sizzle Index
   
• Call Sizzle and Put Sizzle, which measure present-day call or put volume against the previous five-day average
   
• Stock Sizzle, which measures present-day stock volume against the previous five-day average
   
• Volatility Sizzle, which measures the present-day volatility index against the previous five-day average

As a simple indicator, the Sizzle Index can show traders which stocks' options are generating the most interest. A stock trader might consider a high sizzle as an indicator for a potential upcoming price swing. It's also possible to observe whether a high or low Sizzle Index coincides with a big swing in a stock's price. A big move accompanied by a high sizzle might indicate continued strength in that move, just as high stock volume might. A big move accompanied by a low sizzle might indicate that the market expects a lower likelihood of the move continuing.

When considering trading and investing strategies, charts are one tool that can provide traders and investors an idea of a stock's price action. The related options data, however, can potentially provide additional context about whether the market expects that sentiment to continue or reverse.