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The Put Call Ratio
Put Call Ratio
The put call ratio can be used to measure market sentiment. It is frequently used as a contrarian indicator. The way it’s calculated is very simple it’s just the number of puts traded divided by the number of calls traded. You’ll see it quoted a couple of different ways, one is the open interest or OI ratio and the other is volume or VOL. The OI ratio uses the open interest on the option contract and the VOL measure uses the volume over a given time frame.
The dollar weighted put-call ratio is the sum of the put volume times the put price divided by the sum of the call volume times the call price.
Contrarians use the put call ratio under the assumption that the public is usually wrong. So when the public is buying a lot of calls, they’ll short the stock and when the public is buying a lot of puts, they’ll buy the stock.
As with any strategy it won’t work 100% of the time and there have been many times when there has been heavy call buying on a stock and the stock ends up getting taken over. A takeover candidate is not a suitable short sell candidate.
Below is a chart of the AGG ETF as of 11-9-2012, the IShares Core Total US Bond Index. The red line below shows the put call OI ratio at 226.00.
The Iron Condor
The Iron Condor
The iron condor is a defined risk market neutral strategy. It is composed of a bull put spread and a bear call spread put on for a net credit. The risk is defined as the distance between one of the spreads minus the credit received. The investor hopes that the underlying market will stay between the two short strikes and the net credit will be collected as profit. This can be a good income strategy. It can have a high probability of success depending on the width of the condor or how far the short strikes are from the underlying. It can also have a poor risk reward ratio depending on the distance between the short and long strikes on the call and put spreads. The closer the strike prices are together, the less risk there is, but you’ll also receive less credit for the overall position.
Let’s look at an actual example as of the time of this writing. The SPY closed at 137.57. If you had the market opinion that the SPY would not rise by more than $4.43 or fall by more than $5.57 by expiration, you could consider selling an iron condor that would consist of 1 short SPY 132 put, 1 short 142 SPY call, 1 long SPY 145 call and 1 long SPY 129 put. The net credit using the current bid/ask prices and by going out 41 days in time would be $88 for each condor. The risk would be defined as the distance between a spread and the net credit or $212. Volatility is low now so the option prices are not real high. You can get more credit by widening the distance between the spreads, but then there is also more risk. For example is you decided to use a 4 point spread, it would be for a net credit of $104, but now the risk would be $296.
Using the standard deviation is a good way to determine where to place the spread, it can be calculated so that there is a low probability that the underlying will move far enough against you, but you’ll also have the long positions there for the absolute risk control.
The iron condor can be applied when you think that volatility is high and you believe it will fall. If the implied volatility is high in the current month and lower in the farther out months, a calendar spread might make more sense.
SPY Iron Condor
The Covered Put
The Covered Put
The covered call is probably the most popular option strategy used today. It is very simple. Most investors tend to be long stocks and the idea of writing a call option, collecting some premium and being willing to accept a higher price for your underlying equity position appeals to many investors. Covered calls can provide some decent income and limited downside protection while you are waiting for your stock to appreciate to your desired exit price.
The married put is similarly another simple option play that is very common. With a married put, the investor will purchase a stock or an ETF then buy a put for insurance to protect the downside. With a married put the risk is limited and the upside reward in theoretically unlimited.
The covered put is not commonly used at all, yet can be a good strategy. Most investors don’t short stocks, so it is not nearly as common as the two strategies mentioned above. The covered put is just about the opposite of the covered call. The investor will identify a stock or ETF that he thinks has topped out and believes that it’s time for a short position. The stock is sold short and then a put option is sold on that position at a price point that the investor will be happy to buy the stock back. The profits to the downside are limited to the strike price selected and the premium received for the sale of the put. Just like a covered call there is risk to adverse price movement in the underlying, but now it is to the upside.
So, if you think that ABC stock won’t go any higher, you could short ABC say at $25. Then you could sell a $20 put say for $1. If ABC goes below $20 you’ll get assigned, buy the stock back at $20 and close out your position for a $6 profit. The percent return that you’d receive depends on the margin rate that you get from your broker.
Shorting stocks isn’t for everybody, but the covered put can be a viable strategy. As always it’s wise to do some thorough research and avoid stocks that could be potential takeover candidates or that could experience rapid price appreciation for some other reason like a new product announcement, lawsuit getting settled etc. Investors who rely on technical analysis alone should review the fundamentals to see if there are issues like that pending that could impact the price.
P/L Graph for a Married Put
The naked put, selling puts to accumulate stock
The uncovered or naked put is sold when an investor wants to produce income and is willing to accumulate shares of stock. The key difference between an investor and a speculator when it comes to naked put selling is that the investor is targeting a stock or ETF for a long term buy and has set a price that he is willing to purchase that stock at. The speculator is trying to profit by selling the put and hopes it will either expire worthless or he can buy it back later for a profit. The investor is satisfied with either outcome having the put expire worthless or getting assigned and purchasing the underlying shares at pre-determined price. Income is produced by selling out of the money put options at a price lower than the current price of a stock, when the investor would be willing to buy the stock at that price. For example, if XYZ stock is trading at $25, the investor is willing to purchase XYZ at $20. Therefore, she sells a $20 put for $1. If the stock stays above $20, the investor retains premium. If the stock goes below $20, it will be put to the investor at $20. However, the investor already has collected $1 in premium so her cost basis is $19. There are many sources that consider naked put selling to be a risky strategy. However, selling an uncovered put is not as risky as outright stock ownership. If an investor owns a stock that goes to 0, like General Motors, the investor has a total loss. If the same investor sold a put and was assigned on that put to purchase those GM shares, the investor would have retained the put premium even though the shares eventually went to zero. Naked put selling is riskier to the brokerage house because they fear that the investor may not meet the margin call if shares are put to her. If the investor utilizes proper position sizing relative to her portfolio and is using the strategy for stock accumulation uncovered put selling is not a high risk strategy and in fact has the same risk profile as the covered call strategy which is generally considered to be low risk. When stock prices decline, implied volatility has a tendency to rise making the options more expensive. If you’re targeting an entry price for a stock and see it decline rapidly, check the option quotes for a rise in the implied volatility and high prices for out of the money puts. When bad news comes out on a stock that you want to own, that can be a good time for selling out of the money puts. Say you’re willing to accumulate 1000 shares of XYZ over time. You could sell 10 out of the money puts and wait for the shares to get put to you or you could use a fraction of the total, say 2 puts per month and repeat the process until you’ve accumulated the full 1000 shares. When selling naked puts we target investments to accumulate, a price below the current market that we’re willing to buy them at and try to find puts that are relatively expensive. If you’re accumulating shares of a stock, puts will have a tendency to be priced high every quarter prior to the earnings release. This can create an opportunity for the put seller as the implied volatility rises to account for a substantial move in the stock. Out of the money puts can have a higher price at this time and provide an attractive entry point. For investors wishing to accumulate shares in a commodity based ETF such as USO, the oil ETF, the volatility can be higher before the weekly release of the petroleum report. Stock index ETFs can have higher implied volatility prior to major releases of
economic data like the monthly employment numbers or scheduled Federal Reserve meetings. When selling a put you can use the delta to approximate the probability of getting assigned at expiration. An at the money put will have a 50 delta, so if you sell an at the money put you have a 50/50 chance of ending up owning the shares. The at the money puts also have a relatively high premium and will have high theta. As the puts move out of the money the delta is lower so the probability of getting assigned also gets lower as you move out of the money. If you sell 20 delta puts the premium may not be that high, but you’ll only get assigned 20% of the time and your entry price into the underlying will be substantially below the current market price. If you are targeting individual equities with this strategy, you will only get assigned when the stock drops significantly, and you may decide you don’t want to own that stock anymore. It’s very critical to be sure you’re willing to purchase a stock when selling puts. When the strategy is used to accumulate ETF shares in a broad based index like the S&P 500 for example, by selling far out of the money puts on the index, you’ll only buy shares on dips and it can be a good dollar cost averaging strategy for share accumulation in an index fund.
SPY Short Put
