With the S&P500 ($SPY) at 215.04 last as of Friday, October 7, 2016, you can see the price of various options.
I started at 215 which is "at the money" and the prices above that are the call options, since those are "out of the money". I made the call options green, since they are for upside price action. I then graphed the put options prices from 215 and down and made them red, since they are for downside price action.
What you can see is that it costs a lot more to protect against a market decline than it does for a rally. In fact, if you had $1.65-$1.70 to spend on a CALL option, you could get one that was 3.2% out of the money. But if you bought a PUT option instead, you'd have to get one that was 9.3% out of the money, which is ALMOST 3 TIMES FURTHER OUT OF THE MONEY.
Basically speaking you'd have to monitor this every day to see what was a "normal" amount of skew, or price difference between puts and calls that are out of the money. But I think you can see that this is a pretty extreme reading at first glance. The fact that they are different in price is more of a function of how people use options and who initiates the trade to price the option.
Let's walk through the basics:
A put buyer enters an order to buy a put, which gives a put seller the chance to sell. Once the transaction has occurred, the "put seller" generally would prefer to neutralize the position by either selling short a fractional amount of the index, or go out and purchase other put options to hedge off the risk. So after awhile, a market for options that looks like this would imply that a lot of hedging has taken place and nervous longs and bearish speculators have already built their positions and are protected against a market decline. What I would also expect out of an extreme reading like we have now, is that any sharp decline would find a bottom quickly because the hedges are already in place. This is not to say that we can't have any declines, but you wouldn't expect to see a cascading decline or a massive collapse with this much hedging already in place.
It looks to me that the market will more likely edge higher to the 220-225 area into year end as a much more likely possibility to the 198-206 area. The odds are better than 2:1 that this is true, from the way that I see it.
Have a great weekend and hope to continue doing this analysis each weekend until it shows a bearish signal.
I'll be in KEY HIDDEN LEVELS chat room during the week if you have any questions or feel free, of course, to post questions here.
All the best,
Tim
I started at 215 which is "at the money" and the prices above that are the call options, since those are "out of the money". I made the call options green, since they are for upside price action. I then graphed the put options prices from 215 and down and made them red, since they are for downside price action.
What you can see is that it costs a lot more to protect against a market decline than it does for a rally. In fact, if you had $1.65-$1.70 to spend on a CALL option, you could get one that was 3.2% out of the money. But if you bought a PUT option instead, you'd have to get one that was 9.3% out of the money, which is ALMOST 3 TIMES FURTHER OUT OF THE MONEY.
Basically speaking you'd have to monitor this every day to see what was a "normal" amount of skew, or price difference between puts and calls that are out of the money. But I think you can see that this is a pretty extreme reading at first glance. The fact that they are different in price is more of a function of how people use options and who initiates the trade to price the option.
Let's walk through the basics:
A put buyer enters an order to buy a put, which gives a put seller the chance to sell. Once the transaction has occurred, the "put seller" generally would prefer to neutralize the position by either selling short a fractional amount of the index, or go out and purchase other put options to hedge off the risk. So after awhile, a market for options that looks like this would imply that a lot of hedging has taken place and nervous longs and bearish speculators have already built their positions and are protected against a market decline. What I would also expect out of an extreme reading like we have now, is that any sharp decline would find a bottom quickly because the hedges are already in place. This is not to say that we can't have any declines, but you wouldn't expect to see a cascading decline or a massive collapse with this much hedging already in place.
It looks to me that the market will more likely edge higher to the 220-225 area into year end as a much more likely possibility to the 198-206 area. The odds are better than 2:1 that this is true, from the way that I see it.
Have a great weekend and hope to continue doing this analysis each weekend until it shows a bearish signal.
I'll be in KEY HIDDEN LEVELS chat room during the week if you have any questions or feel free, of course, to post questions here.
All the best,
Tim
Subscribe to my indicator package KEY HIDDEN LEVELS $10/mo or $100/year and join me in the trading room KEY HIDDEN LEVELS here at TradingView.com
If you pay about 0.9% premium on either side, calls are half the distance from the market. Whereas before it was one-third the distance. Down-spikes find support when put premiums are expensive. The next level is to look for open interest and see if there are any high open interest levels.