By Covering Business March 25, 2013
By Sameepa Shetty
Columbia Journalism School C’13
For journalists, the stock market is an important source of information. Its broad movements can reveal a great deal about what investors are feeling at any given moment and how they think current events might impact the economy. The same can be said for individual stock prices. When they go up or down, that’s a signal that investors’ confidence in their companies has changed.
There is another source of information about investor confidence, one that reporters use less often but that can offer them a far more detailed picture: options. These contracts allow investors to place bets on stocks hitting specific peaks, valleys or ranges by a given date. Options trading activity offers a window into where sophisticated investors believe a stock or basket of stocks is headed – and when it’s going to get there.
Reporters who know how to interpret options activity have an immediate leg up. They get access to early clues about shifts in broad market sentiment, as well as the suspicions of savvy investors about surprises and flaws underlying individual companies.
The options industry itself is also a wellspring of stories. The emergence of ever more complex investment vehicles has prompted new calls for tighter regulation of the derivatives markets, where options are traded. If you’re going to cover stocks, you should know a little about how options work and how to use the data they provide in your stories.
Options are a type of derivative, a financial instrument that derives its value from another asset like a stock or group of stocks. In this case, they guarantee the holder the right to buy or sell some amount of a stock at a certain price.
There are two basic types of options. A call option gives the holder the right to buy a share of the underlying asset at a preset price known as the strike price. A put option gives the holder the right to sell that asset at the strike price.
Because options offer the holder some flexibility, they are often used to hedge larger positions in the same stock. For example, say an investor owns 10 shares of Acme Widgets that he bought at $50 each but believes the stock is poised for a steep fall. By purchasing a put option to sell the stock at a strike price of $45, he can lock in that sale price even if the stock falls to $40, $30 or $10. In effect, he’s bought himself some protection to manage his risk.
Many investors use options not only to hedge their positions, but also to turn a profit. An option is said to be “in the money” if the movement of the underlying asset has made it profitable. For example, say Acme Widgets is now trading at $100. A trader purchases a call option that allows him to buy the stock at $105, no matter how high it goes. If Acme jumps to $110, the option becomes “in the money.” The trader can now profit on the deal.
Of course, options contracts also cost money themselves. Their prices vary with the duration of the option and the value of the underlying asset.
The idea of options is almost as old as the financial markets themselves, but the first standardized options trade for the general public opened on April 26, 1973, when the Chicago Board of Options Exchange opened for business. That day, 911 contracts were traded on the exchange. In April 2012, more than 4.3 million contracts were traded per day on average.
Today, options contracts are listed on a number of exchanges, including the CBOE, the Chicago Mercantile Exchange, NYSE Euronext, Deutsche Börse and InterContinental Exchange. (Options can also be traded over the counter, but the market is unregulated and driven by custom contracts between two parties.)
The Options Clearing Corporation, the only clearing organization for options trading, is regulated by the Securities Exchange Commission for its activities in securities and by the Commodities Futures Trading Commission for futures.
As with the stock market, trading volume is a helpful way to put options activity into context for readers. The busier the day, the higher the volume.
The ratio of puts (selling contracts) traded to calls (buying contract) traded is a good gauge of sentiment about a particular stock or group of stocks. A put-call ratio greater than one suggests traders are bearish on an option’s underlying asset. Individual stocks have their own put-call ratios, but so does the broader market.
A stock’s implied volatility is an estimate for how much options traders expect it to move in a single day. A sharp rise suggests traders predict the stock will move a lot in either direction.
A stock’s options premium is the difference between the cost of a call (buying contract) and a put (selling contract). A high premium suggests the options market is betting a sharp rise in the underlying asset.
Open interest is a measure of the most active options for a particular stock. It indicates where the market is placing the most bets. Open interest refers to the number of options sold by a market maker to a customer, or by a customer to a market maker, that are still active. If the seller reverses the transaction (an option owner sells the contract, or the option seller buys the contract back), then that interest is closed.
The websites of the main options exchanges publish data about trading volumes and active options. They also put out daily, monthly and annual market reports.
Separately, the OCC publishes market statistics and industry research on its website.
Several media organizations report regularly on the options market. Bloomberg TV, among others, airs an options update every day, in which traders discuss why they’re buying certain options at particular strike prices. CNBC.com publishes daily videos identifying trades in the options market.
Because traders use options to bet on upward movement in a stock and minimize their downside risk, it’s difficult to read too much into the data. For example, rising put action coupled with a rising stock does not necessarily mean a bet that the price will fall. It could be merely a natural part of traders’ strategies to buy a put for a stock they already own to hedge that position.
Options data offers strong directional hints about a stock and can be a good starting point for further reporting, but it should always be backed up with fundamental research, including analyst commentary and interviews with institutional investors.
This entry was posted on Monday, March 25th, 2013 at 5:45 am. It is filed under Featured and tagged with CBOE, CBOT, DOJ, investing, options, SEC, stock market, stocks. You can follow any responses to this entry through the RSS 2.0 feed.
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