Option Action Lacks Conviction

Option traders were treated to an unusually active end of summer. According to the Options Clearing Corp., option volume during the week before Labor Day, usually among the lightest of the year, saw 28.7 million contracts trade, or some 5.6 million contracts a day. That's a 39% increase over the same week a year ago and greater than the year-to-date average daily volume of 5.5 million contracts.

Typically an increase in volume is interpreted as a bullish indicator, as more interest, more speculation and more liquidity are necessary to drive and sustain higher prices. But despite last week's surprising surge in volume, recent option activity is not presenting an entirely bullish picture. In fact, the last two sessions, in which we are supposed to see a post-Labor day pick-up, have seen a decline in trading volume, suggesting a lack of commitment from investors.

First, it's important to realize that much of the year-over-year increase in option volume comes from the proliferation of exchange-traded funds, the increase in hedge fund activity (which tends to be non-directional) and the increased adoption of strategies utilizing options to reduce risk rather than committing new money to the market.

During the last seven trading days, the equity-only put/call ratio's 10-day moving average has climbed to 0.67 from 0.59, suggesting recent activity is protective rather than speculative in nature. More telling is that the put/call ratio on index products has held steady at a protective 1.56, which indicates that institutions are buying broad market protection even as stocks have rallied.

This protective position has been especially evident in small-cap issues. For example, over the last week the Russell 2000 iShares ( IWM) has seen a dramatic increase in put option open interest, sending its put/call ratio to 2.89, its highest level in six months. From a contrarian point of view, this should be constructive, as it points to an underlying distrust or worry about stocks ability to move higher.

Another important option gauge is the CBOE Market Volatility Index, or VIX, which measures the implied volatility of the S&P 500 options. It's important to remember that the VIX is a measure of the implied volatility of the S&P 500's 30-day options. The fact that the VIX hit a 10-year low of 10.33 in late July was more a reflection of the index having been bound within a narrow trading range than a sign of complacency.

Indeed, during August, when the S&P was trending down, the VIX was the mirror image, staging a monthlong climb that hit a high of 13.96, and culminating on Aug. 29, when hurricane Katrina hit land and the market marked a bottom.

The S&P has since climbed some 2.7% and the VIX has declined 10% to 12.56. Usually a surge in volume and a decline in the VIX would be a sign of optimism or bullishness. But right now it seems that investors are taking advantage of the low volatility to buy cheap options to reduce risk. This can take the form of either purchasing put protection or buying calls to replace long positions, both of which are forms of risk reduction. While this may represent a healthy level of prudence and caution, it is not the type of activity that propels stocks to new highs. Until volume turns back up, the upside will be limited.

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 appreciates your feedback; click here to send him an email.

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