Option volume: Profiting from the volatility trade

Traders are accustomed to viewing option volume through the lens of put/call
By assessing the proportion of option volume going into put
options vs. calls, we hope to gauge the sentiment of the market. Suppose,
however, that we simply look at option volume itself as a barometer of the
degree to which traders are attempting to capitalize on volatility. Some
of these traders are selling volatility, hedging against adverse market movement
or simply anticipating that premiums will revert to levels dictated by their
models. Other participants are volatility buyers, speculating that
premiums will expand or seeking cheap ways to play for anticipated short-term
market movement. When option volume is high relative to its recent norms,
we know that many traders are attempting to profit from the volatility trade;
when option volume is relatively low, there is less interest in trading

Why is this important? When option volume is high, we have a relatively
high conviction that underlying assets are mispriced. Market participants
are expressing conviction that the market is wrong and that they can exploit
this inefficiency. Conversely, when option volume is low, traders have a
relatively high confidence in the pricing of the underlying assets. They are expressing comfort with the market’s appraisal of value.

It turns out that this degree of conviction or comfort exerts short-term
impact on the S&P 500 Index
Quote |
Chart |
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. Since 2004, we have had 73 trading
sessions in which SPY has risen by .75% or more. When this rise has
occurred when option volume in common stocks (excluding indices) has been high
relative to its 20-day average (N = 36), the next two sessions in SPY have
averaged a gain of .12% (24 up, 12 down). When the rise has occurred
during a period when option volume has been low relative to its 20-day average
(N = 37), the next two sessions in SPY have averaged a gain of only .01% (17 up,
20 down).

This suggests that short-term rises have tended to continue when they occur
against a backdrop of pricing uncertainty. When markets are comfortable
with the pricing of the underlying stocks, short-term returns after a rise are

How about declines?

Since 2004, we have had 83 occasions in which SPY has dropped by -.75% or
more. When this decline occurs against the backdrop of high relative
volume among the options of listed stocks (N = 42), the next two days in SPY
average a gain of .22% (24 up, 18 down). When the drop in SPY occurs
against the backdrop of low option volume (N = 41), the next two days in SPY
average a loss of -.02% (18 up, 23 down).

This tells us that declines are more likely to reverse when they occur during
a period of high market uncertainty about pricing. When the market drops
and option traders are relative comfortable with premium levels, the decline is
more likely to persist. Since 2004, bulls have been benefiting from
pricing uncertainty; bears have profited from pricing comfort.

The moral of the story is that there is an active market in volatility, just
as there is an active market in oil, equities, or Treasuries. Rarely do
non-professional traders view this as a separate market, with its own patterns
of trend and activity. Knowing how volatility is moving and how
aggressively it is being traded provides information of real relevance to stock
and index traders alike.

Brett N. Steenbarger, Ph.D. is Associate Clinical
Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical
University in Syracuse, NY and author of
Psychology of Trading
(Wiley, 2003). As Director of Trader Development
for Kingstree Trading, LLC in Chicago, he has mentored numerous professional
traders and coordinated a training program for traders. An active trader of the
stock indexes, Brett utilizes statistically-based pattern recognition for
intraday trading. Brett does not offer commercial services to traders, but
maintains an archive of articles and a trading blog at www.brettsteenbarger.com
and a blog of market analytics at www.traderfeed.blogspot.com.
His book, Enhancing Trader Development, is due for publication this fall