Summary Because options are risky and complicated, we tend to purely and simply ignore them. But they carry information. Let us try to reach this information. An effective instrument of observation of the options market should replace the endless series of figures by graphical representations. As soon as we have defined the main charts of our tool, we are able to distinguish some basic patterns. Using these basic patterns, special situations and complete stories can be deciphered: example of the Kraft-Heinz merger. Conclusion: For a stock investor, it’s worth observing the options market. Why try to observe the options market? You can’t trade options if you don’t know anything about the underlying stock. In actual fact, the option trader and the stock investor have exactly the same basic need: they first must gather quality information about the (underlying) stock they are interested in, then they must, in one way or another, get an idea of its future prospects. But there is a very big difference: the option trader runs a much higher risk. One can easily guess that most of the options traders dedicate to the preparation of their decisions much more means than the individual investors. They undergo specific training and often are professionals employed by large firms (more resources, more time, more contacts). It should be added that option trading can be the royal road to take the best profit from insider information. So, we can say that there exists a population of option traders whose operations may bring valuable information to the average stock investor. How can we observe them? The following article tries to answer that question. A few words about options If you are not familiar with the matter, it is strongly recommended that you first read Investopedia or Wikipedia. You must know what the words contract, call, expiration date, in-the-money, LEAPS, open interest, premium, put, strike price, underlying asset, mean. You can leave aside the technical stuff (Black-Scholes model, Cox-Ross-Rubenstein model, greeks, …) After this first reading, there is one aspect that has to be explored a little farther: Options are perishable securities (they are born, they live, and they die), and their cycle of life is an integral part of the exchange system. The following points merit consideration: Types of orders When you give an order on the options market, you must specify if you intend “to open” a new position – which will be added to your portfolio, or if you intend “to close” a position – an existing position which is already part of your portfolio. So there are four types of orders… sell to open sell to close buy to open buy to close … which combine into three types of trades, which in turn can be denominated as follows: trade to open: a sell-to-open associated with a buy-to-open trade to transfer: a sell-to-open associated with a buy-to-close (transfer of the obligation), or a sell-to-close associated with a buy-to-open (transfer of the right) trade to close: a sell-to-close associated with a buy-to-close Open interest, volume, exercises, and expirations Options are created by one single event: trade-to-open. They are (in part) transferred by one event: trade-to-transfer. They are destroyed by three events: trade-to-close or exercise or expiry. Accordingly, we can say that the open interest at the end of a trading session is equal to the open interest at the beginning plus trades-to-open minus trades-to-close minus exercises minus expirations. This is rather theoretical because the available statistics don’t provide this level of detail. Nevertheless, this has to be kept in mind in order to avoid a misleading interpretation of the relationship between volume and open interest. Durations of life When we consider the possible durations of life of options, we distinguish three categories: Weekly options: they have a maximum duration of a few weeks, and they expire at the end of any Friday other than the third one in the month. Monthly options: they have a maximum duration of a few months, and they expire each month at the end of the third Friday. LEAPS (Long-term Equity Anticipation Securities): they have a maximum duration of at least two years, and they expire at the end of the third Friday of January. Building an instrument of observation P rinciples If we leave aside the idea of putting microphones in the offices of some selected options traders, we have little choice: we’ll use the daily market data. For each optionable stock, we group together all its options (around 200 on average) into a small number (around 10) of ” equivalent options,” each having most of the attributes of an option. These equivalent options are … global equivalent call: all the calls global equivalent put: all the puts monthly equivalent call: all the calls expiring during a given month monthly equivalent put: all the puts expiring during a given month … and their attributes are : open interest volume weighted average strike price (abbreviated in “wasp”) weighted average expiration date (abbreviated in “waed”) weighted average premium (abbreviated in “walp”) (all the weighted averages are calculated using the open interest) After calculation of the corresponding aggregated data, we can draw charts. Main charts You easily imagine that many charts can be defined. For the purpose of this article, we’ll focus on three of them: “the ribbon,” “generations at a glance,” “life of a generation.” Main charts – The ribbon: This chart compares the global equivalent call “wasp” (as defined above) and the global equivalent put “wasp” to the price of the underlying stock. Below, we see SPDR S&P 500 ETF (NYSEARCA: SPY ): (click to enlarge) We call “ribbon” the area bounded by the two curves representing the “wasps.” In the case above, the ribbon enfolds the curve of the underlying price. This has something satisfactory, because we have the spontaneous feeling that the rightful place of the call “wasp” is above the underlying price, since a call is linked to an anticipation of increase of the underlying, and the opposite feeling about the puts. This feeling corresponds rather well to the reality when the expiry of the global equivalent occurs in the near future. But in the case of iShares MSCI Brazil Capped (NYSEARCA: EWZ ) … (click to enlarge) … the ribbon doesn’t enfold the price of the underlying. This reveals the existence in the distant future of huge open positions having “wasps” largely disconnected from the current underlying price, as we’ll shortly see. At last, the chart is usefully supplemented by the indication of the weights used in the calculation of the “wasps,” namely the open interests: (click to enlarge) (click to enlarge) Main charts – Generations at a glance This chart shows the distribution of the global equivalent call and put into the monthly equivalents. Let’s have a look at SPY: (click to enlarge) We’ll call “generation” the set of a monthly equivalent call and a monthly equivalent put. On October 30, we count 14 generations for SPY. Their open interest (call + put) ranges from 12 152 contracts in Sept. 17 up to 6 550 619 contracts in Nov. 15. 68% of the global open interest (20 947 910 contracts) is concentrated before the end of 2015. Now, EWZ: (click to enlarge) We count 7 generations, and 27% only of the total open position is set before the end of 2015. Obviously, traders here look at the distant future much more than for SPY. Main charts – Life of a generation The definition of this chart refers to definitions already made: it is the ribbon drawn exclusively with the data of one given generation. Here is the July 2015 generation of SPY: (click to enlarge) This generation is born on March 24 and ceases to exist on July 31. Note that the edges of the ribbon enfold the underlying price during the whole life of the generation. As for the open interests, they steadily gain in number between March 24 and the beginning of July. During July, in accordance with the definition of what is a generation, expiry dates follow one another on every Friday. Thus, we can see 5 tips corresponding to the five Fridays of the month: Thursday 2 (Friday 3 being an exchange holiday), Friday 10, Friday 17, Friday 24 and Friday 31. The biggest decline, as always, occurs at the end of the third Friday. And now, EWZ. We have seen for this symbol that: the global equivalent ribbon doesn’t enfold the underlying price, and we have suspected that such a thing could be caused by huge open positions in the (relatively) distant future. the heaviest generation is Jan. 2016 Accordingly, let’s have a look at this Jan. 2016 generation, from its birth in November 2012 until October 30, 2015: (click to enlarge) The long duration of this generation is due to the fact that it contains a LEAPS, which was initiated on Nov. 12, 2013. We can see that, after some hesitation at the very beginning, the setting up of the ribbon enfolds the price of the underlying. But afterwards, the latter declines sharply, and the ribbon doesn’t completely follow – because the traders have a good lapse of time in front of them. How does such a situation come to an end? To answer that question, we can look at the January 2015 generation, which closely resembles the January 2016 generation. It ended as follows: (click to enlarge) Between August 13, 2014 (beginning of the chart) and December 19 after a short increase, the underlying price plunges: the ribbon doesn’t evolve very much, the open interests continue to grow until December 19, 2014. After December 19: between Dec. 19 and Jan. 16 (third Friday of January): given the previous big plunge of the underlying price, on one hand, the call contracts are all worthless and their open interest remains constant (the green dotted curve shows a flat plateau), on the other hand, a number of put contracts are profitable, they are sold to-close or exercised and consequently the open interest decreases (the red dotted curve). on Jan. 16 (the big drop): there is a very little volume (puts as well as calls), and the major part of the remaining contracts expire worthless at the end of the session. between Jan. 20 and Jan. 30: there exists very little activity – and we are satisfied to see that the ribbon now encloses the underlying price. Some basic patterns Once the charts are defined, feeding them with the market data allows us to observe some patterns. I’d like to show you four of them : “saw tooth profile,” “profit taking session,” “call cliff, put cliff,” “straddle peak.” Basic patterns – Saw tooth profile Let’s consider the following symbol : AAPL150821P00125000 It identifies an option contract having the following attributes: the underlying asset is Apple Inc. (NASDAQ: AAPL ) , the expiration date is August 21, 2015 , it is a Put, the strike price is $125.00 Besides, we know that: the contract was created on April 20, 2015. from the contract birth to its expiration on August 21, the share price of Apple declined from $127.60 to $106.05. Here is the chart drawn with the historical volume and open interest of that precise contract: (click to enlarge) There are 3 periods: first, a period of growth: the trades are mainly trades-to-open, and the open interest grows to just under 80 000 contracts. then, a period of stabilization: not very pronounced here, it can be reduced in some cases to a single sharp summit or, on the contrary, extended to a long flat plateau. at last, a period of decline: trades are now mainly concluded to-close, some contracts are exercised (here something like 40 000 one day before the expiry), and the remaining ones expire worthless (here a little less than 20 000 at the end of Aug. 21). This fundamental pattern exercises an influence on a good number of our charts, as we are going to see immediately. Let’s go now to the highest level, the market as a whole. Here is the chart drawn with the total open interests, calls and puts, of the market (stocks only) over a period of 750 trading sessions (approximately 3 years): (click to enlarge) Each of these contracts have in time a profile similar to the AAPL150821P00125000 one that we saw above, and they combine into a saw tooth profile which is absolutely characteristic of the option market. We can see very clearly the three rhythms of expiration: weekly, monthly, and yearly (each year the tip on the third Friday of January is followed by the biggest decline in the year). We must be aware of these scheduled drops of the market in order to correctly identify the actual falls. Basic patterns – Profit taking session Between mid-October 2014 and December 29, the Cisco Systems, Inc. (NASDAQ: CSCO ) share climbed from $22.82 up to $28.46. After such an increase, no wonder if there is some profit taking. We can see here in the white window a remarkably synchronized profit taking session (immediately after the top of the underlying price): more than 200000 call contracts are sold to-close on December 31 (the drop from 800k to 600k of the dotted green curve). The contracts which are sold are those having the lowest strike price (the most profitable), consequently the average strike price of the remaining ones increases (continuous green curve). (click to enlarge) This pattern – on the same day a decrease of the call open interest and an increase of the call “wasp” – is characteristic of a call profit-taking session. Now let’s look at a put profit-taking session. It occurs on September 29, 2015 after the impressive drop of the underlying Sunesis Pharmaceuticals, Inc. (NASDAQ: SNSS ) on July 23. A little more than 5000 contracts are sold to-close (the drop of the dotted red curve). The contracts which are sold are those having the highest strike price (the most profitable), consequently the average strike price of the remaining ones decreases (continuous red curve). (click to enlarge) This pattern – on the same day a decrease of the put open interest and a decrease of the put “wasp” – is characteristic of a put profit-taking session. We can close this point by noticing that profit taking is one of the mechanisms by which the ribbon tend to follow the moves of the underlying. Basic patterns – Call cliff, put cliff A “cliff” is a brutal and strong increase of either calls or puts, for the purpose of taking advantage of an anticipated increase or decrease of the underlying price. Here is a recent call cliff on Comerica Incorporated (NYSE: CMA ). (click to enlarge) The “Generations at a glance” chart shows that it is concentrated on the January 2016 generation: (click to enlarge) What happens later? On November 25, it seems that the owner(s) of the position took the good decision, at least partly … (click to enlarge) … and for the moment (end of the story in January 2016). Here is an example of put cliff on October 29: It concerns LifeLock, Inc. (NYSE: LOCK ) at a moment when there is some uncertainty around the agreement announced as reached between LOCK and the FTC. Apparently, the buyer of this put position thinks that the increase of the underlying price will not last long. (click to enlarge) A quick verification … (click to enlarge) … shows that the option bet is concentrated in the immediate future. A few days later, after the expiry of the November generation … (click to enlarge) … the bet appeared as lost. Basic patterns – Straddle peak A straddle peak reveals the implementation of a straddle strategy linked to an announced event having an announced time-table: someone thinks that the event will cause moves of the underlying price. As you know, a straddle strategy implies the same number of calls and puts at the same strike price and the same expiration date. In other words, things go by pairs (open interests on one hand, “wasps” on the other hand) at the same pace in the same direction. Here is the beautiful straddle peak observed on the occasion of the July 2014 CBS Corporation (NYSE: CBS ) divestment. (peak on July 10, 2014): (click to enlarge) And below, as seen on November 25, 2015, the General Electric Company (NYSE: GE ) – Synchrony Financial (NYSE: SYF ) spinoff: the GE side: (click to enlarge) and the SYF side: (click to enlarge) A complete story: the Kraft-Heinz merger A call cliff appeared in the Kraft Foods Group, Inc. (KRFT) ribbon chart between mid-January and mid-March 2015: someone thought it was a good idea to buy 60000 call contracts. (click to enlarge) The chart “generations at a glance” suggests that two generations are used: March and June 2015 (click to enlarge) The point is confirmed by the examination of the stories of these two generations. March 2015 generation: (click to enlarge) June 2015 generation: (click to enlarge) Then, on Wednesday, March 25, the announcement of the merger of Kraft-Heinz occurred. As a result, the price of KRFT surged more than 35 % : (click to enlarge) It was too late for the bet invested in the March equivalent call, which had expired worthless a few days before on March 20: (click to enlarge) But the bet invested in the June equivalent call was certainly highly profitable. We recognize the profit-taking pattern in the white window below. The interpretation is a little disturbed because the profit-taking session, which occurs on April 7 (the decrease of the dotted green curve associated with the increase of the continuous green curve), is immediately followed the next day April 8 by an opposite movement – but there is no doubt, the profit-taking pattern is here. (click to enlarge) Conclusion You work hard, you save for your retirement, and your savings are precious. You take a thousand precautions before acting – or not acting. You read papers, blogs, financial newsletters. You are subscribed to various financial websites and often participate in forum discussions. Fundamentally, in most cases, you listen to what people say . We just saw that options data can reveal what people do – on the options market. Observing them can bring you valuable complementary information, and also stimulate your own thoughts. November 26, 2015 Postscript: I don’t have any position, and don’t plan to give any order, in any of the stocks (and their derivatives) mentioned in the article. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.