Market Indicator for the Week Ahead
October 17, 2011
Buy-to-Open Option Activity on the VIX



The buy-to-open (BTO) call/put ratio on CBOE Market Volatility Index (VIX) options has continued to decline, and is now approaching extreme lows. Fund managers often hedge their equity exposure with call options on the VIX, as it tends to rise strongly when the market declines.

Looking inside the market can give us clues about its future direction. Put/call ratios provide us with an excellent window into what investors are doing. When speculation in calls gets too excessive, the put/call ratio will be low. When investors are bearish and speculation in puts gets excessive, the put/call ratio will be high.

A brief understanding of Buy-to-Open & Put/Call Ratio before looking at this week’s indicator.

Buy to Open

Buy-to-open is a term used by many brokerages to represent the opening of a long position in option transactions, either call or put options.

Investor can buy to open either (or a combination of) puts or calls, and thus will be holding the option(s) long. The distinguishing factor of a buy to open is that the option position is not held short in the account during the transaction.

Put/Call Ratio

Put/Call Ratio is the ratio of the amount of put options traded versus the amount of call options traded.

Put/Call Ratio is used by options traders around the world as a contrarian indicator of market sentiment. As an indicator of market sentiment, Put Call Ratio tells you when investors are in a bullish or bearish mood. There are many types of Put/Call Ratios and many ways to interpret it.

Indicator Enlightened

S&P500-20day C/P ratio

Driving the Ratio

In any ratio, there are two components: a numerator and a denominator. As a result, the decreasing call/put ratio could be caused by a decrease in calls, an increase in puts, or a combination of both.

Below is a chart showing the average buy-to-open calls and puts over the last 20 trading days. It shows a dramatic drop-off in BTO calls, and at the same time, a dramatic increase in BTO puts. In other words, fund managers are no longer hedging long equity exposure, and instead may actually be shorting the market, and buying VIX puts to hedge their short positions.

S&P500 - 20day - puts - calls

Below is a chart of total short interest along with the S&P 500 Index (SPX), which supports our theory from above. This shows a big increase in short interest lately, confirming that fund managers may be increasing their bearish bets.

S&P500 - shares short


The implications obtained from this analysis above, points toward the conclusion that fund managers are becoming increasingly gloomy, and are now starting to short the market. As long as the short selling persists, it can be a major headwind for the market. However, the very first chart shows the VIX's buy-to-open call/put ratio getting close to an extremely low point. This is a sign of potentially climactic pessimism, which -- as you can see from the chart -- often leads to market rallies.


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