Using data from the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) we at Schaeffer’s have created a unique option volume indicator which has recently crossed above a level that suggests an increase in short-term volatility may be on the horizon, or at least the volatility of volatility. Let me explain.
This indicator looks at “Buy-to-Open” activity only, and is derived from taking the daily sum of Index Put volume and dividing this figure by the daily sum of Equity-only Call volume.
In theory, this indicator measures “Hedging activity”. An elevated ratio suggests a degree of panic and desire to hedge portfolios, while a low ratio suggests a degree of euphoria as BTO volume is driven more so by Equity call activity, and not hedging activity (Index Puts).
In addition to following the daily option activity, we like to observe a 10-day moving average of the daily data. In the chart below which begins in 2009 (the year we began collecting this data), I plot the indicator with the VIX (CBOE Volatility Index).
It is clear that the indicator has had a high correlation with the VIX in the past, the VIX is an instrument synonymous with fear and derivatives of the VIX are often used by hedge funds and portfolio managers to hedge their long exposure.
There has been a desire recently to hedge portfolios as the ten-day average has moved higher. During the second quarter of 2011, this indicator led a massive VIX rally whereby the VIX rallied 105% in just three days. Events such as the Italian election and the release of Fed minutes where Federal Reserve members voiced dissent against QE and suggested an earlier than expected exit from quantitative easing have been responsible for recent fears.
In the table below, I have the VIX returns after the ten-day average rises above 0.70. For comparison, I also include the at-any-time returns of the VIX at the bottom of the table. The last instance of this occurring was on Thursday, February 28th, 2013.
Will the recent option activity and increase in this ratio move concurrent with Volatility as measured by the VIX, or will the “Hedges” already in place be sufficient to stem the decline? The standard deviation of results after this signal suggest a big move is imminent one way or the other. It is also important to note that after 21-days, or roughly a month of trading, volatility not only reverts to its mean, but it actually has declined after a trigger of this unique option volume indicator.
If you have any questions, concerns, or comments regarding this study or a derivation of, that you would like me to study or look into, please leave a comment below. I can also be followed on Twitter: @ChrisPrybal