One of the only noticeable trends occurring in the options market lately is a significant increase in trading volume. During the first two weeks of October, the average volume across all six option exchanges was 5.2 million contracts per day, a 20% increase over the first nine months of the year and a 32% increase from average daily volume in September.

But the pickup in volume is sending very mixed signals, and might prove to be a temporary blip, rendering any meaningful sentiment or directional signal from the data difficult or inconclusive, at best.

The first fact to consider is that the recent jump in option volume is coming off a relatively low base; in the two weeks before and after Labor Day, both the equity and options markets logged six of the eight-lightest volume trading days of the year.

The statistics show that overall option volume has ramped up: Through the first nine months of 2004, option volume increased 22% over 2003 levels; through last Friday, October's volume is up 8% vs. last year's pace.

Actively Neutral

An increase in volume is usually deemed initially bullish as more interest, more speculation and more liquidity should support higher prices. But the recent increase has some negative undertones.

First, it's important to realize that most of the increase in volume is due to the proliferation of exchange-traded funds, the increase in hedge funds' domination of trading, and the increased adoption of strategies utilizing options to reduce risk rather than a commitment of new money to the market. While options volume has surged -- with some 160 issues trading double their daily volume over the last week -- and implied volatility increased from a nine-year low of 12.90 to 14.60 Monday, 81% of the volume has been in put options.

Usually a surge in volume would be a sign of euphoria. But in this case, it seems to be smart money taking advantage of cheap volatility. This took the form of either purchasing put protection or buying calls to replace long positions, both of which are forms of risk reduction. From a contrarian point of view, this should be constructive as it points to a wall of worry.

But a look behind the put/call data muddles the picture; during the seven trading days between Sept. 28 through Oct. 6, while the indices were rallying strongly, the equity-only put/call ratio averaged just 0.57 -- well below the 21-day moving average of 0.71. The implication in that being a preponderance of call activity and speculation just as the averages were making three-month highs and testing important resistance levels. But the put/call on index products remained at a protective 1.45, or slightly above its 21-day moving average of 1.42, which indicates that institutions were buying broad market protection as we head into earnings season.

It is interesting to note that the weighted put/call ratio, which provides a better measure of speculative vs. protective activity, is still near three-month lows; this confirms that the put activity is mainly protective (purchasing out-of the monies) rather than bearish speculation, which would entail buying closer-to-the money or more expensive put options.

Still Hanging Low

The other important option gauge is the CBOE Market Volatility Index, which measures the implied volatility of the

S&P 500

options. It declined to 12.90, a new nine-year low, during the first three days of September. While this is ostensibly a sign of complacency, it's important to remember that the VIX is a measure of the broad index options. As such, it is tethered to the

S&P 500's

30-day actual volatility which, due to hedging and range-bound trading, has been below the 11% level for three out of the last four months. Many individual issues have seen an uptick in volatility over the last week, but this was mostly in anticipation of earnings releases and likely will prove temporary.

Interpreting both the put/call and volatility readings based on direction rather than absolute levels suggests that until the weighted put/call put call reading jumps above its 21-day moving average and the VIX rises above 16, the broad indices will remain in a range-bound market, defined by their descending trendlines.

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.