Is Light Option Volume Saying it's Time to Buy?

trading volume

I’ve been awol a little lately.  First I went to an option trading seminar last weekend so that took me out of commission for a few days.  I’ll have to tell you about it, but that’s a topic for another post.  Then Wednesday morning my wife had surgery.  Nothing major (don’t tell her I said that), she just had a bunion removed.  She’s still off her feet and will be for a while .

Obviously, she’s been keeping me busy.  Anyway, here’s an article that surprised me.  It’s about how the volume of options traded actually dropped in February.  All you hear about is how option trading volume is going through the roof, so I was shocked when I read this.  It may actually be an opportunity though.  Read the article and decide for yourself’

The Options Clearing Corp. (OCC) released its monthly figures on options volume last week, revealing that fewer options traded hands in February when compared to the same period a year ago. For the month of February 2012, equity options volume declined 6.27% on a year-over-year basis, though it grew by a little over 4% on a month-by-month basis when compared to January 2012 figures. Given the current market conditions, the month-over-month growth trend is more important for you to focus on here.

One of the themes we’ve heard from analysts regarding the market lately targets the recent trend of low equity trading volume. The theory that is bandied around, quite a bit, is that a low-volume trading environment is bad for stocks as it suggests participants have yet to “engage” themselves in the market. Continuing this theory, this would suggest that any gains posted over the last few months are likely to reverse. One might think the same would apply to options volume, but as is often the case with options, a contrarian view of this data is more likely to yield tradable information.

The chart below illustrates the average options trading volume, by month, since January 2008. Since 2008, the general trend in options volume has been on the rise, which makes sense since we continue to see growth in the use of options as an investment. What is interesting are the periods identified in the chart (by green circles) where average monthly options volume reversed from a declining trend to an ascending one, signaling that options traders are starting to get more active again.

Daily Option Volume Since January 2009
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Loosely speaking (especially since we are dealing with monthly data), these reversals in options volume have been bullish for the market, which makes sense. One of the best rules of contrarian investing is that “the best time to buy is when everyone else is selling.” Conversely, “the best time to sell is when everyone is buying with both hands.”

Somewhere in between, there’s a sweet spot. There’s always a point at which investors start sniffing around and begin buying again. If you find that, you can ride the wave of new money coming into the market that drives prices higher.

It is my belief that the new trend in options-volume data is flashing signs that we’re entering that sweet spot as options activity is on the rise again. If historical trends play out again, we should see a rise in investor activity over the coming months. The bad news? The crescendo of that activity will mark the point where investors are hitting a buying frenzy. And that’s the point that you and I should be searching for the exits. Until then, enjoy the ride.

Another (arguably better) way of interpreting option volume data is via the CBOE equity put/call ratio. This indicator provides a daily look at the same type of data and therefore offers better and much more frequent insight. Check back next week when I will further discuss this indicator and how you can use it in your equity and options research.

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