Contrarian Indicator

wjexchange said: "I just joined this thread today and I am looking for some comments on the following... It’s been said that 80% of options purchased, expire worthless. That being the case, it seems that the odds of profiting from pure directional plays, ie., purchasing puts and calls are rather slim. Option open interest represents the number of contracts that are currently unsettled. For every long position, there must be an offsetting short position. Open interest in a particular option contract will only decrease when the option is either exercised or it expires. Open interest will increase when a trader writes an option on an underlying position held [or goes naked]. When an option is exercised, the holder of the option agrees to buy or sell the underlying issue at the strike price of the option. If a holder of a call option with a strike price of 30 exercises, then he is obligated to purchase the underlying stock at $30 a share. The exercise process then forces a netting out of the long and short option positions and the open interest is reduced by the number of contracts exercised. While there are a number of indicators that attempt to place a fair or expected value on options, there is one element that is often overlooked. When options are purchased, they typically go off at the “ask”. When options are sold, [or written] they typically go off at the “bid”. Therefore, if we buy into the premise that most option buyers lose money, then it is reasonable to assume that most option sellers [writers] make money. I would like to see an indicator that tracks option trading volume based on whether trades go off at the bid or the ask price. It stands to reason, that if the smart money is selling options [presumably at the bid] and the not-so-smart money is buying [presumably at the ask], then the higher the ratio of bid/ask volume, the more bullish the outlook is for the underlying stock. Conversely, if the trading volume is heavier on the ask side, it means that there is more interest in going long on the option [buying] than going short [selling]. A low bid/ask ratio indicates heavy interest in buying. If 80% of directional traders ultimately lose money, then the outlook for the underlying stock must be bearish. This premise flies in the face of traditional supply and demand dynamics. That is, heavy interest in buying reflects strong demand, while heavy selling is indicative of weak demand. This posit takes the opposite view and clearly suggests a contrarian strategy. Comments?"

Rickster said: "I think your basic premise is sound. But there are some flies in the ointment. First, I dont know of a source that compiles the data, although some brokers do provide time and sales for options. Years ago I had access to (i.e. paid for) and watched options T/S as a contrary indicator. It worked at that time. Second, I have had good luck in the last year in getting my buys to go off at the midpoint of the bid ask spread. But I think most people probably dont try. Third: Although it is true that 80 some percent of options expire worthless on a bean count basis, the winner/looser split between buyers and seller is more balanced, and shifts in cycles. Sellers make money with frequent little wins. Buyers make money with infrequent big wins. A few years ago, the easy money was in buying options. Now it is in selling options. Oh. Welcome to the board."

holzie said: "Sounds logical, but I don't see it as very practical. The amount of daily research required would be extreme. Definitively this would be something for the full time option trader. Good post though, we like ideas around here. Welcome to the board. Holzie"

holzie said: "[QUOTE=Rickster] Second, I have had good luck in the last year in getting my buys to go off at the midpoint of the bid ask spread. But I think most people probably dont try. Third: Although it is true that 80 some percent of options expire worthless on a bean count basis, the winner/looser split between buyers and seller is more balanced, and shifts in cycles. Sellers make money with frequent little wins. Buyers make money with infrequent big wins. A few years ago, the easy money was in buying options. Now it is in selling options. Oh. Welcome to the board.[/QUOTE] Buying off midpoint still works well with very liquid options, like the Q's and SPY's. Impossible to do with products like SPX or DJX (traded only on CBOE). I totally agree with your third conclusion. It is true that most options expire worthless but it doesn't mean that they were not owned by speculators before expiration for swing gains. It is true that sellers make their money by steady smaller wins and buyers usually make it on infrequent large gains. But this does not put either party into a dissadvantage or an advantage over each other. Both players have to be smart risk managers. Obviously, ultimately, somebody has to loose some money for someone else to make money......wealth is only transferred in the market. But if you are a hedged option seller like DrDan and I, you will see that in the beginning, there are days when you are down on your spread, even when you are way in your desired range. That's just the nature of the game. Us sellers have only one thing going for us, that's time decay. Good points all around, Rick. Holzie"

wjexchange said: "Hey guys, great comments. Finally a board willing to share civil and thoughtful observations. [B]THE SPREAD...[/B] it'll get you everytime if you are not disciplined. Investors new to trading credit and debit spreads, especially on thinly traded options, need to understand that the commissions are only a minor part of transaction costs, and it is buying at the ask and selling at the bid that really eats away profits. As to my original post regarding options trades occuring at the bid or the ask price, it just seems that this would be natural "drill down" data worth analyzing from widely publicized put/call [sentiment indicator] ratios. --wj"

holzie said: "[QUOTE=wjexchange]Hey guys, great comments. Finally a board willing to share civil and thoughtful observations. [B]THE SPREAD...[/B] it'll get you everytime if you are not disciplined. Investors new to trading credit and debit spreads, especially on thinly traded options, need to understand that the commissions are only a minor part of transaction costs, and it is buying at the ask and selling at the bid that really eats away profits. As to my original post regarding options trades occuring at the bid or the ask price, it just seems that this would be natural "drill down" data worth analyzing from widely publicized put/call [sentiment indicator] ratios. --wj[/QUOTE] You are absolutely right...the spread can eat a large chunk of your position. Commissions, thank god, are not a factor in my trading anymore, thanks to Thinkorswim. As I said above, in my relatively limited options experience, you can get around the spread problem by trading highly liquid options traded on multiple exchanges. You will get MARK almost every time. As far as those limited products like the SPX goes, well I love cash settled, European style index options so I am willing to give up some dough to get filled. On condors, what you can do is instead of buying all your 4 legs at once and giving up 0.10 per leg, you can "leg into" it either by doing a 2 vertical spreads at your price or 4 option trades at your price (buy 1 call, sell 1 call, buy 1 put, sell 1 put). This is sort of a lengthy way of doing it but it will get you a better fill price overall but not MARK by any means. You are basically not showing your cards to the market maker at once. Ih the MM knows you want to do an IC, he is obligated to still give you the best price based on the spread but that's it. He knows you wanna get in. But if you are legging as 4 separate trades, he doesn't know you are doing a condor and he "use" you (in your advantage) to get rid of some of his "excess" inventory. Dan Sheridan from the CBOE says this is a standard way of trading for the MMs. Holzie."