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Beware the Limits of Implied Volatility

Traders most often use broad market measures like the put/call radio and volatility index (VIX) as gauges of market sentiment -- that is, whether traders are bullish or bearish.

And as measures of emotion, they are most often viewed as contrary indicators. That is, if the masses are extremely bullish, as indicated by these metrics, it could spell trouble and a signal to sell.

Although interpreting data in this light is certainly valid and often useful, there are also situations in which activity in the options pits can accurately predict or presage an impending move in the underlying stock.

Contrary readings are predicated on the belief that prevailing investor sentiment -- revealed through price, volume and open interest configuration -- is often wrong, while the predictive approach to options activity says that sometimes this information actually reveals what the "smart money" is doing, and therefore is correct on its face.

The challenge is distinguishing the latter from the former.

Contrary indicators are typically used to identify a significant change in price direction; the buy and sell signals are usually generated when readings hit extreme levels in reaction to an identifiable event. Predictive options activity (which might provide a "tell") is characterized by above-average option activity and a change in implied volatility for no apparent reason. Outside of an extremely high put/call or VIX reading, option activity is a more effective predictive indicator for individual issues than for broad indices or the market as a whole.

The Price Is Right

One of the first steps in using options as a predictive indicator is to appreciate the level of sophistication and knowledge of professional traders and market makers. The most obvious and easily measured data point to illustrate this is price, reflected specifically in the implied volatility applied to a given option. "If implied volatility is high, there is usually a good reason," says Tom Hough, a market strategist with PTI Securities. (For a list of options definitions, please check out my glossary for the Options Alerts newsletter.)

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