The Length of Options Ownership Predicts Equity Prices

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Felicity Cannon
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1 The Length of Options Ownership Predicts Equity Prices Bill Rafter President, Mathematical Investment Decisions, Inc. Abstract By calculating the average holding or accumulating time for put and call equity options one will determine that more active participants are more profitable. One can also follow their lead to considerably improved profitability. 1

Abstract By calculating the average holding or accumulating time for put and call equity

2 One contention of some investment professionals is that investors or speculators who hold a position longer earn more than those who hold for less time. It is not only possible to show a pattern of examples to the contrary, but it is also possible to use that information for profitable future investing. To put it simply, more active investing, or at least a more active review of one s investment positions, has advantages over less of the same. Options are sometimes considered as the tail on the dog, with the dog being equities investing. With options the market practitioner has more information, specifically the open interest (OI), which enables more detailed analysis. First, some basics not commonly known, the understanding of which is critical: Over any given period the number of new options positions can be determined by adding the volume to the change in open interest ( OI ). New Positions = Volume + Change in Open Interest For example, on Tuesday the volume was 1, and the open interest increased by 1. The number of new positions was 2 (one new long and one new short). There were no liquidations, which are the volume minus the change in OI. If you then keep a time series of the new positions you can compare a backwards moving sum of that series to the current level of OI. That is, how many days of new positions did it take to accumulate the current level of open interest? Historically it turns out to be about 22 trading days. But it varies for puts and calls as well as for equity options (on individual securities) and index options, and of course varies considerably over time. Note that this derived data does not need smoothing which would introduce both lag and bias. Without smoothing a decision rule is more timely. You need to see if the average holding time (or accumulating time if you wish) for puts is longer than that for calls, or vice-versa. What you will find is (to coin a phrase) whoever holds longest is wrongest. Methodology After creating the series of daily New Positions, take a moving sum of their daily values backwards from the latest day until that moving sum exceeds the current level of OI. However many trading days it takes is the number of days over which that OI has been accumulated (or held, if you prefer). Do this for both equity puts and equity calls, and take their difference: Net Options Age (NOA) = Equity Puts Holding Time - Equity Calls Holding Time The result is an oscillator (about zero). If the NOA value is positive, puts are being held longer than calls. You can imply your own meaning to such a circumstance, but I suggest that the holders of calls are being more nimble than those of puts, or alternatively the put holders are not watching their positions as closely. It turns out historically that when this happens, the equities market rises. Here is a chart illustrating the oscillator and the contemporaneous market (SPY): 2

To put it simply, more active investing, or at least a more active review of one s investment positions, has advantages over less of the same.

3 Charts can be deceiving, so let us put the statistics on the table. During the period of the study, which was dictated by the availability of the options open interest data, the SPY (total return) had a 5.77 percent compounded annual rate of return while experiencing a percent maximum drawdown. That s the benchmark. If however you were to go long SPY whenever the NOA oscillator crossed over from negative to positive (greater than or equal to zero), and to move to the 3-month Treasury Bills whenever the opposite occurred, you would earn 9.63 percent annually while only experiencing a percent maximum drawdown. That is a substantial improvement over the benchmark. 3

77 percent compounded annual rate of return while experiencing a 55.19 percent maximum drawdown. That s the benchmark.

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Positions were taken on the close of the day following the day of the crossover. That is, if the crossover occurs on Monday, you execute the trade on Tuesday s close.

5 Positions were taken on the close of the day following the day of the crossover. That is, if the crossover occurs on Monday, you execute the trade on Tuesday s close. The first day you experience the return is then Wednesday. The simulation is thus realistic. Should you have traded the opposite way, you would have had a negative 2.89 percent compounded annual return. [The positive of that would have also been the return for a short-seller, not including borrowing costs.] Of course the primary advantage of the proposed strategy is avoidance of the major drawdowns, along with accompanying client flight. Since late 2001, there have been only 23 crossovers from long to short and 22 vice-versa. This is a rather small population. There are consequently not enough crossover observations for good statistical reliability tests. However even a non-astute observer would opine that the signal is clearly not random and (once being made aware) he would be cautious against making a large financial commitment against it. The relatively small number of crossovers is both good news and bad news. The bad news is that determining statistical reliability is hindered, but the good news is that it is a consistent nonfluttering indicator. Let s look at what would happen on an ongoing basis. Out of 421 non-overlapping 5-day periods in which one would be long, 257 experienced profits while 164 were losses. Out of 226 non-overlapping periods in which one would be in T-bills, 112 would be profitable and 114 would be losses. And of course that includes the profitable periods from just being in T-bills. Conclusion Those who watch and adjust their options positions more frequently tend to be more accurate than those who take a laissez-faire approach. And furthermore that fact has implications for the overall equity market. The advantages of NOA are several: 1. It has a very good track record. 2. It s easy to calculate. 3. It rarely flutters between buy and sell signals, tending to stay on message along with the market. 4. The logic behind it is intuitive it makes sense and is easy to explain to clients. 5. The default position is to be long equities. 5

89 percent compounded annual return. [The positive of that would have also been the return for a short-seller, not including borrowing costs.

6 6. As the options business expands in the future (e.g. the growth of weekly options) its accuracy should not wane. 7. Timing of entries and exits is not as crucial as with most other such tools. That is, it is good at providing continuation signals. Author s Thought: Typically the uses of put and call data are considered sentiment indicators and are viewed as contrarian. I would encourage an opposite approach. With NOA you are identifying which side is more active in response to its view of the markets, and choosing to be on the observant side rather than on the more complacent side. Other benefits: Although NOA can be used to trade an index ETF (such as SPY) rather than buy-and-hold, we ourselves use it to identify those periods which we deem reasonably safe for actual stock rotation. View it as plunge protection. I suggest you calculate holding times for equity puts, equity calls, index puts and index calls, as all of the series have usefulness. For example, if you are ever in a quandary as to the most significant period over which to smooth equity data, the time periods identified by the holding time here have relevance, contrary to a fixed time period of say 50 days. Of course, the holding times change, so you must code to enable adaptive input. Faced with different holding times, you obviously should choose the shortest, since you now know that the longest is a poorer choice. Notes on Data: The data is obtained from the Options Clearing Corporation, and I have included in this study all that is currently available (from March 2001 to present). Options volume data is watched by many; options open interest data is less so

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Stock Market Dashboard Back-Test October 29, 1998 March 29, 2010 Revised 2010 Leslie N. Masonson

Stock Market Dashboard Back-Test October 29, 1998 March 29, 2010 Revised 2010 Leslie N. Masonson My objective in writing Buy DON T Hold was to provide investors with a better alternative than the buy-and-hold