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Options Forum: A Change in Sentiment

Heavy buying and strong open interest can have a big impact.

Steve:

In yesterday's Columnist Conversation you mentioned the large amount of May put-buying in the $34 and $35 QQQs. You said that regardless of the reason for it, "the fact that it is concentrated in near-term expiration dates should provide some near-term support." Could you please explain this?Thanks,-- C.B.

The reader is referring to some remarks in

Columnist Conversation

that I posted last Monday, which addressed the potential impact that options activity and open interest can have on the market.

On Monday, the

Nasdaq 100 Trust

(QQQ) - Get Report

hit an intraday low of $34.42, which represented a dramatic 7% decline during a nine-day period. Fear was clearly setting in the air, prompting a rush to buy downside protection through the purchase of put options. The magnitude of the put activity in the May $34 strike was eye-popping. It became apparent the next day that most of the volume comprised new purchases, as open interest in the strike doubled to some 660,000 contracts. To put this in perspective, the June $34 put, which is the strike of peak open interest for that month, currently has 315,000 contracts open.

The put/call ratio in the QQQs May options is now about 2.01, meaning that the current open interest is composed of twice as many puts as calls. A put/call reading above 2.0 is an indication of extreme bearishness. However, because the put/call ratio is considered a gauge of investor sentiment and is used as a contrarian indicator, that huge pop in the QQQ's front-month put/call reading could be taken as short-term bullish signal.

This large open interest in the May puts could provide support, because all that broad-market put protection acts as a safety net. It gives money managers more confidence to buy dips knowing they have an insurance policy that will kick in at a certain price level.

In this case, that protection is now in place at $34, which also happens to represent technical support at the March 23 low. As of midday Friday, we've seen the QQQs maintain a trading range this week between $34.50 and $35.50, with Wednesday's dramatic afternoon rally being the highlight. What will occur between now and next week's expiration remains to be seen.

Steve:Could you please elaborate on your comment that the VIX "has risen 22% in the last 10 days and needs to drop to below 15 to complete a spike formation marking a short-term low?" How much does it need to spike and retrace over what time period, and what's the probability of a correct signal? I hope this applies to VXO, as I still use it for its history.-- R.H.

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Once again, the reader is referring to a Columnist Conversation post, this time

from Tuesday.

The Volatility Index, or VIX, which measures the near-term implied volatility of the

S&P 500

index options, is another favorite sentiment and contrarian indicator. As fear rises, people tend to purchase put-option protection, driving up the cost of options. A peak in option prices has a good track record of signaling market bottoms or turning points.

But I think many people fail to look at the VIX on a relative basis, as well as an absolute price basis. To this end, many people had been calling a market top all through last year's rally, on the basis of the VIX's steady decline to what eventually would be its lowest level in eight years. They interpreted this low reading as a sign of complacency and therefore a bearish signal.

But rather than thinking in terms of specific price levels, such as "The VIX is low at 15 and we are due for a selloff," or "At 40 the market will start to rally," you should look at the index's direction, or more importantly, for a change in the VIX's direction.

Even though the VIX has risen some 20% during the last week, it has yet to pull back enough to form a peak. It's the up-and-down movement or arc that it's showing -- not the absolute price -- that should act as an inverse indicator of the market's direction.

When I first posted my comments, the VIX had climbed from 15 to about 18. It then hit an intraday peak of 20.5% on -- guess when? -- Wednesday, the big reversal day that saw the S&P 500 rally about 2% from its intraday low in the final two hours of trading. But even though the VIX has now retreated back to 18.5, it is still up about 22% over the last month and has yet to pull back enough to form a peak.

Calling the Bottom
The VIX's peak coincided with a recent market low

It will take a similar such reversal to form a peak and indicate that the market has found a near-term bottom. Since the VIX moved higher from my original post, I'm adjusting the corresponding level upward, and I now think that a close below 16.5 (rather than the previous 15), which would create a small peak or reversal in the VIX, would provide a buy signal that the worst of the selling is over.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.