News ReleaseRecord Put/Call Ratio — What’s Going On?
Options AI
Multiple headlines in the past few weeks highlighted record-high put/call ratios (PCRs), typically a bearish sentiment indicator. Investors may be growing increasingly bearish into 2023, but institutional traders know that other things could be going on too. The PCR is the number of put options traded divided by the number of call options traded for a given period of time. A PCR of 1 means the number of buyers of calls is the same as the number of buyers of puts. Over the past few weeks, the market has seen days with a PCR above 2.0 So What’s Going On? Not only are we in a bearish market with investors growing more cautious, but we are also seeing higher interest rates for the first time in years. Higher interest rates result in a more significant cost to carry long stock positions and price of options contracts (rho). Additionally, a down market has left large open interest in now deep-in-the-money (ITM) put options. This situation allows professional traders to target a specific type of arbitrage opportunity in which they target puts in high open interest contracts as part of a zero delta spread and then early exercise those puts. To explain, here’s an example of how this might work. Two traders target deep ITM, high open interest put strikes by crossing a 0 delta put spread (buying a 100 delta put while selling a 100 delta put as a net zero delta put spread) with each other (for the max value of that spread). The traders then early exercise the long puts on their spreads. Because assignments are given out randomly rather than directly to all those that are short that strike, each trader is only assigned one part of their spread. That leaves them with a short stock vs. a long 100 delta put. What Does This Mean for Me? From a market perspective, the volume associated with this professional arbitrage activity means that the PCR may be somewhat distorted as an indicator at the moment. More importantly, everyday investors should be aware of this activity, since the options they have sold may have a higher chance of being assigned. Here’s an example. You sold 10 contracts of a credit put spread in XYZ stock. The stock price falls below the short and long strike of the spread, implying that the spread may expire at maximum loss. However, prior to expiration, the 10 short put contracts are early assigned, where the original spread of -10 puts / +10 puts transforms into a +1,000 shares / long 10 puts position. The position still has defined risk but no immediate cause for alarm. However, now your account must have sufficient funds to own 1,000 shares of the underlying stock. If your account does not have sufficient funds to own the stock position, you will likely face a margin call that is due on the stock settlement date (2 business days after the assignment). In other words, your brokerage will request that you post sufficient funds. If you cover the margin call, you might carry the position. If you don’t, either you or your brokerage will want to immediately close the position. If you don’t meet the margin call by posting sufficient funds, you still have several options, including closing the position or exercising the long option. In a high-interest rate environment, another factor enters the frame. Even if you exercise the long put to flatten the stock position or if you sell the assigned stock, settlement of the exercise (or stock sale) is also 2 business days. Since you are reacting to an assignment that took place the previous day, you’ll face at least one business day where you will need to borrow funds to carry the long stock position. Worse, the settlement mismatch may occur over a weekend, meaning you must now borrow funds for 3 business days. And, even worse, a holiday would mean that you must unavoidably borrow funds for 4 days. In a low-interest-rate environment, borrowing money is obviously relatively cheap. You may not even notice the interest charge applied by the clearing broker, relative to the original known maximum loss of the trade. In a new high-interest rate environment, the consequences increase. If a 10-contract assignment translates into 1,000 shares of stock worth $300,000, and despite immediately closing the position, your settlement straddles a holiday weekend, you could end up with 4 days of interest at say, 8%. That’s over $250 in interest that would need to be factored in on top of the original maximum loss of the spread. Creating Strategies in an Ever Changing Market The new reality is, in this market of higher interest rates, early assignment on deep ITM options will happen more often. What can traders do to avoid the borrowing costs of early assignment? You can find strategies to avoid the borrowing costs of an early assignment. More active trade management often holds the key. Conduct regular scanning of winners and losers that have moved deeper ITM and might be prone to assignment. Take winners and losers off sooner by closing positions earlier. A good rule of thumb is to look for positions that are at or near 100 deltas on long and short strikes. Close those positions when they are at or near max loss or max gain before they have the chance to be early assigned. This post contains sponsored advertising content. This content is for informational purposes only and is not intended to be investing advice. Contact Details Options AI Options AI support@optionsai.com Company Website https://www.optionsai.com/
January 30, 2023 02:16 PM Eastern Standard Time
