Diving Deep Into Option Volume Trends with Market Chameleon

Will McBride and Dmitry Pargaminik, cofounders of Market Chameleon join IBKR’s Senior Trading Education Specialist Jeff Praissman to take a deep dive into current option volume trends.

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Note: Any performance figures mentioned in this podcast are as of the date of recording (March 22, 2023).

Summary – IBKR Podcasts Ep. 68

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman

Hi everyone, welcome to IBKR Podcasts. I’m your host, Jeff Praissman, Interactive Brokers’ Senior Trading Education Specialist. It’s my pleasure to welcome back the Co-founders of Market Chameleon, Will McBride and Dmitry Pargamanik. Hey guys, how are you?

Dmitry Pargamanik

Pretty good, thank you.

Will McBride

Hey Jeff, thanks for having us.

Jeff Praissman

Oh, my pleasure. As always, it’s great to have both of you back in the studio. In a previous podcast, Episode 53: Understand Option Volume Trends with Market Chameleon, we discussed certain option volume trends and today we’re going to pick up where we left off and take a deeper dive into the trend categories as well as what, if anything, has changed in the past three months? When we left off guys, short-dated options were all the rage. Are they still the most popular?

Dmitry Pargamanik

Yeah. If we look at the total volume typically in the day, you see about 42% of the option volume concentrated in the weeklies, anything that’s less than five days to go. But I think what’s grabbing a lot of people’s attention are those Zero DTEs, zero days to expiration options and they don’t exist for every equity, you only have it in a few places particularly SPY, QQQ and what we see is that on a given day, more than 1/3 of all the volume in SPY are in those 0DTE options. And I think that actually it’s a little bit interesting because when we looked at the history of option use, typically you saw people buy-write, they owned stock and they would try to make income by selling an option against it two weeks, three weeks, four weeks out and maybe check on it once a day, every other day or buy a put to protect your position. We also saw people using options around events we talked about before. There’s an earnings event so they would come in, try to position themselves prior to their earnings and then exit out of it right afterward, and then that option volume will come down. But what makes the 0DTE options interesting is it’s a completely different type of trader, and this is a trader very active and wants to be flat at the end of the day, and they’re looking to trade that day, not carry positions and the next day they’ll come back and trade those 0DTE’s again. But basically, they’re just looking to trade those options that will expire today, going out flat at the end of the day. This looks like a pretty active and big group of traders out there that is a completely different use of options than we were used to historically.

Will McBride

What do you think these traders are doing now? Is it intraday positions? Are they using it instead of actually trading the underlying? Why are they trading these zero days expiration?

Dmitry Pargamanik

Good question. I think that people are trying to start figuring out what are they using these options for. What kind of strategies are they using on those 0DTEs? And if we just kind of step back and look at it from day-to-day, one of the things that ODTE’s offer them is that without having to carry the positions they don’t have that overnight risk and they don’t have the carrying costs. So, when you trade it, when you have a position that you have to carry, there is a capital cost to that position. You would have to put up that capital, either borrow money or whatever you are to carry that position. Here, they don’t have to do that and they don’t take that overnight gap risk. So, when they’re using these options, what I see is most of it is just concentrated on the strikes right around at-the-money. Usually, it’s just single-leg option trades, so I think something like 85% of them …  it’s usually single-leg trades concentrated on strikes that are at-the-money and as the stock moves, what we see is they start rotating those positions closer to the strikes around the at-the-money.

Jeff Praissman

It seems like only at-the-money strikes or even out-of-the-money strikes trade. It seems to account for almost all the volume. It seems like from your research the at-the-money stuff might be the short-dated and the out-of-the-money stuff maybe might be some longer data stuff I’m guessing, but it seems like there’s very little volume, almost zero, for in-the-money items.

Dmitry Pargamanik

Basically, that’s because of what options offer and what type of exposure you’re looking for when you use options. And when we look at the options, we do see about 20% … well maybe it’s a little bit wider range, maybe 10 to 20% of the options are what I would call tail risk or even lottery style options. These are very cheap options that people will trade that are far out of the money and the low probability of those ever making money. Then you have the speculative options between like the 10 and 25 delta, that’s about 1/4 of the volume. The rest of it is really around the at-the-moneys where you have a lot of gamma and Vega exposure. But I think what happens with the deep in-the-money options is that when we look at something very deep in-the-money, there aren’t that many strategies for end users using those deep in-the-money options because when you’re very far deep in-the-money, it has what we call like a one delta. It starts to move one for one with the stock. So, the stock moves up a dollar, the option moves up a dollar. Stock moves down a dollar, the option will move down a dollar in the case of a call option. When that happens, you don’t have any more gamma. There’s no more gamma, there’s no more Theta or premium in there. There’s no implied volatility. It just kind of starts to act like a stock and if somebody wants exposure for directional risk, then the stock is more liquid than that option. So, the option will be wider than the stock itself in those deep in-the-money options. So, in that case, you’re just better off using the stock. But yes, the most popular options will be the ones that are closest to the at-the-money. We do see options that are more speculative between the 25 delta, 10 delta and there is a decent amount of volume in those tail risk options. Either out-of-the-money puts or out-of-the-money calls that are cheaper and have a low probability of making a profit, but a potentially high reward if that hits.

Jeff Praissman

Got it, got it. And in kind of taking a step away from just strike price and kind of just talking about calls and puts, what does the put-call ratio say about where the investors believe the stock is going?

Dmitry Pargamanik

That is a popular ratio to look at, the put-call put right? The open interest and the puts versus the open interest and the calls or you could look at the volume on the day in the puts versus the volume in the calls and the assumption there is that puts are bearish bets, calls are bullish bets. If you look at the ratio, you could kind of figure out are people more bullish or bearish? But I think that that indicator right now is not really a good indication of that because that’s taking all the put open interests, all the put volume versus all the call open interest and the call volume. But people don’t trade calls and puts that way and I’ll give you an example. If somebody trades a large credit put spread … so a credit put spread would be selling one put buying another put and if you do it in a credit put spread you kind of have a bullish outlook. You want the stock to stay above that short strike. But in the put call ratio, it will take all that volume, the entire spread, and look at it as that’s bearish, those are bearish puts.

So, when you look at that ratio, it’s not a very good indicator because it doesn’t treat all that volume equally no matter what the trade was or if it was a multi-leg trade, single-leg trade, part of something. You know, it could have been a contingent trade with stock. It just looks at the open interest and treats all of that as bearish and the calls all as bullish. And of course, that’s not how people only use options, and it might not be even at this point way I’m looking at the options with all the multi-leg trades and the way people are selling options. I don’t even know if the majority of the trades are bullish call buying or bearish put buying. So, I don’t think that would be a great indicator of sentiment and I don’t think it would be a great indicator of directional sentiment because people are not using those options like maybe they did a very long time ago. The use cases have changed.

Will Mcbride

And wouldn’t it be D, would that put call ratio … I mean, if it was really things were getting bearish, wouldn’t the vol. be going up? You’d want to make sure the vols. are going up too in the market?

Dmitry Pargamanik

Yeah, implied volatility would probably be a little bit of a better indicator of people’s expectations of increased volatility, which is saying that there’s more uncertainty in the markets. So, the implied volatility might be even a better indicator of the VIX of peoples’ anxiety or uncertainty about where the market may be going than the put-call ratio. Unless you could take the trades and slice them out, you know, to really isolate “Here’s the volume where these are obvious put buyers. Here’s the volume where there’s obviously call buyers.” Maybe if you could compare those and track it, but taking the number, the total number, I don’t think it’s a good idea. Will’s right, the implied volatility might be even a little bit of a better indicator. Also the term structure, so when you see an inverted term structure that’s indicating that right now the market sees a lot of uncertainty.

Jeff Praissman

And looking at volumes over the course of quite a long time at this point, it seems like the top ten stocks are almost 50% of the volume right now and the top 100 are over 80% of the total volume. To me, it seems like a lost opportunity not to trade the full universe of options. In your guy’s opinion, why are there just certain options that seem to be winning at the volume game and other option classes that are just basically virtually ignored?

Dmitry Pargamanik

I think when we look when we look at the volumes and the options, it is very clustered around or concentrated on the most widely held securities. In particular, you’ll see the SPY, QQQ, and then you’ll see some of the top stocks like Tesla, Microsoft, Apple, Netflix, Meta. And I think that the reason is that when people use options as a tool, they typically look at implied volatility. They look at the volatility of a stock. They look at the historical volatility and they’ll use the option pricing model to guide them on trading these options. So, when we look at single stock equities that are not as widely held, that don’t trade as much, don’t have as many analysts … what happens is that pricing those options you start having to do more homework, the volatility is not enough. You need to really understand those stocks better to price that probability distribution. I’ll give you an example like we just saw what happened to the SVB bank. And prior to this crisis, somebody even tweeted out, “Hey, I’m looking at this bank and I’m seeing issues here. They have all these bonds on their book that with unrealized losses they’re marking to maturity. Held to maturity.” So, they didn’t take those losses yet and I’m seeing —

Will McBride

That tweet was like back in December, right? It may have been longer.

Dmitry Pargamanik

It was a while ago, right. It was really a while ago. In addition to that, he noticed that there are a lot of withdrawals in the bank, right. So, the people were not adding to deposits, they’re taking them out. And this created tail risk for that bank, right? All of a sudden you couldn’t price an option just based on its historical volatility. You really needed to know that hey, there is something going on here. You’d have to do your homework. You’d have to really even know what to look at and how to analyze this particular security to understand that the tail risk of this option is really starting to climb because there is a higher probability every month this continues. That this bank could just fail and that requires you to do a lot more homework, right? To price options based on other factors than just the simple inputs that you plug into the Black Scholes model because there is no input into the Black-Scholes model of what we were just talking about. You could input implied volatility assumptions. You can put interest rates or dividend, but this is something that would involve a much higher level, higher sophistication of analysis. And that’s why I don’t think we see as much volume in those single stock equities, especially that are less liquid and not covered as much by analysts.

Jeff Praissman

In that particular case, certainly would have been a huge opportunity for someone who was willing to do their homework.

Dmitry Pargamanik

Exactly. If you’re willing to do your homework, then there’s probably a very big opportunity there but you would have to go beyond looking at historical volatility and implied volatility. You would have to go into a deeper analysis of that security.

Jeff Praissman

Now I want to talk about trade count and what that signifies. And what I mean by that is you see 100,000 contracts trade and you see it as one trade versus you see 100,000 contracts trade and you see it in lots of 100 throughout the course of the day. What does that signify to you guys?

Dmitry Pargamanik

So, there’s a difference between volume and number of trades or orders coming in and sometimes you’ll have a big trade that could be a single trade. Somebody wants to buy like 1000 contracts, but that will get split up between multiple exchanges, they’ll sweep the exchanges, and it could add up to 10 different orders. So really, we would group those together and look at it as a single trade that got split up, but somebody tried to buy 1000, and did it within milliseconds. He swept the book on multiple options exchanges. But then there are other orders that could be only for one lot or 10 lot and what you want to see is well, what is the typical order size in the security and then you could also monitor the number of orders. So, if there are stocks or an equity trades 1000 contracts per day but if there’s only one trade, that means there are not that many people interested in, because there’s only one single trade. But if we see 1000 contracts, trade and we saw 500 different orders with one lots and two lots that means a lot of people are probably interested, especially if it’s distributed throughout the day equally through different strikes and people are doing different things. That will indicate to us that there are a lot of eyeballs on this particular security, and they’re probably trying to do different things according to their unique output.

Jeff Praissman

What about notional versus contract value volume? So to kind of phrase it differently, 1000 contracts trade and the notional value is $2000 versus a thousand contracts trade and the notional value is $10,000. Same number of contracts but different value. If you can kind of go into that for our listeners as well.

Dmitry Pargamanik

When we look at option volume or unusual option volume, usually we get top number right? A top line number. Well, here’s the volume to 1000 contracts, but that only tells you part of the story and once you start breaking down the volume, you could have many stories in there. It’s kind of … think like CPI. It’s a top line number and if it’s going up well, what’s making it go up? Is it food? Is it energy? Is it car sales? You know, so you start breaking it down. So, one of the things to look at is when you look at the volume, if a lot of volume isn’t very cheap options, let’s say a penny options, then the notional value or the total dollar invested will be very low. If the 1000 contracts are in expensive options or moderately expensive options than the notional value will be much bigger. A thousand contracts for $10 a contract is much higher in notional value than 1000 contracts for a penny. So, the notional value is trying to look at is the dollar volume in the option contracts versus just the number of contracts, so it’s putting in terms of dollar value.

Jeff Praissman

And then I think we sort of touched on this earlier with the zero dated options and the short-term options as far as they’re not available for every product right now. I believe just probably ETFs and some indices, and I don’t think there’s any individual stock — I could be wrong — but I don’t think there’s any individual stock that has daily options at this point. What effect has ETFs had on the option volume and clearly that’s one of them?

Dmitry Pargamanik

It’s interesting with the SPY because when we look at the option volume, we try to convert the option volume into deltas of these trades and the deltas of these trades are trying to let us know well, how much of the stock volume or equity volume can be explained by these active traders in the options of volume? So, we approximate. So, if there’s very little volume in the option and the stock trades a lot then the option players have very little influence on it. If there’s a lot of option trades relative to the stock volume, then option traders can have a lot of influence on that demand and supply of that stock. When we look at SPY, the SPY options are so liquid that if we count it, if we took every delta of every trade and said that every trade somebody hedged that delta using SPY, then the volume in SPY would already exceed its average daily volume. In other words, people are using the options and not hedging it instead of the SPY. And a lot of it will have to do it with those 0DTEs because at the end of the day you’re just going out flat. Either the option will expire or will be in-the-money, which you could just close out. So, what we’re seeing as far as options in in the ETFs, a lot of traders are opting to just go to the options markets and use the options markets exclusively to gain exposure to that ETF.

Jeff Praissman

What do you guys consider unusual options volume and what are some causes of it?

Dmitry Pargamanik

When we talk about unusual option volume, it would be different for each security, right? So, each security kind of has its own volume profile. So, SPY trades a lot more on a daily basis than like Wayfair or or Coinbase or some other security. So, first what makes it unusual is that the volume would have to be much greater than what we typically see. And there are instances where there is seasonality to options volume like let’s say around earnings, the volume will pick up. So around earnings you’re going to see more volume than you do on a typical non-earnings day, but even though the volume ticked up, that might not be unusual around earnings, right? So, you would have to kind of track the volume and track the volume across different periods and different events and try to figure and then by comparing the current volume to historical volume, you could kind of see this is much greater than what we what we usually see and then you could kind of try to go in there and figure out what’s causing that. And really during events you’ll you will see volumes pick up. People will use options around earnings events, FDA announcements. So those do make the volumes … typically they will go up around that. There’s some news out there that will make volume go up, but sometimes you just see a new player coming in or, you the Reddit people, they created their own their own interest in their own stocks and then the options exploded around those securities that they were tracking.

Will McBride

Yeah, and different sectors, you have different reasons for volume spikes like in the biotech industry, there may be FDA announcements that people play around those dates. And right now, we were talking on the morning show, someone was asking for information around Fed activity and all of a sudden that’s been something that has led to a lot of participation in the options markets because people are placing positions around the Fed and even trading interday. It’s an ever-moving target what drives the volume for sure.

Jeff Praissman

Takeaways are you got to always pay attention. Kind of look at the historical reasons and kind of make your own judgments as far as what may or may not be unusual given a certain individual option class.

So, Will, Dmitry I want to thank you guys for coming by. I want to remind our viewers that Market Chameleon is a frequent contributor to the IBKR Campus. To see more education materials for Market Chameleon, go to ibkr.com, click on “Education” in the top right and go to IBKR Campus. Then click on our contributors and look for Market Chameleon. IBKR clients can also subscribe to Market Chameleon quickly through Interactive Brokers. And another reminder to our listeners that all podcasts can be found on our website under the “Education” tab or on Spotify, Apple Music, Amazon Music, PodBean, Google Podcasts, and Audible. Thank you for listening until next time, I’m Jeff Praissman with Interactive Brokers.