Option Moneyness & Put Call Ratio
We are all in search of that hidden edge on the markets. That slice of information that when used appropriately can give us outsized gains over the rest of the crowd. The only problem is that most of this information is reserved for a chosen few. Either that or it's ridiculously expensive to attain. But what if I told you there was a cheap and effective way to get hold of this. A free resource to better read the Bitcoin markets and be two steps ahead. Well, in the following chapters I'm going to explain how you can use the Bitcoin options market to your advantage. Not only when it comes to option analysis but also when trying to determine Bitcoin's price direction. All that is to help equip you with the tools you need to get the market edge. I want to start with a quick beginner's overview of options. An option is a financial instrument that gives the holder the right to buy or sell an asset at a pre-specified time and at a pre-specified price. A call option gives you the right to buy the asset, whereas a put option gives you the right to sell the asset. Because these options are instruments that give you optionality there is a cost that comes with them. This is the option premium and it is the price of the option. Options are themselves derivative instruments that are traded on their own market which is separate from the spot market. You can think of it as analogous to the futures and spot markets. There are a lot of variables that will impact on the premium of an option. These are collectively called the “Greeks” and they are inputs into the legendary black skulls pricing equation. If this appears daunting to you don't worry. All you need to understand are the main drivers of an options price. The first thing that i want to introduce you to is the moneyness of the option. This refers to whether an option is in the money or out of the money. Basically, if you're looking at a call option if the spot price “S” is above the strike price “K”, then the option is in the money.
Example: S > K options is in the money or ITM.
Conversely, if the spot is below the strike it is out of the money. Example of that is: S < K Options is out of the money or OTM.
When you have the strike equal to the spot then it is at the money. An example of that is: S = K options is at the money or ATM.
For a put option you just flip the arguments for the in or out of the money levels. The moneyness of an option is important as it impacts on the delta variable in the black skulls. Delta is a measure of how sensitive the price of the option is to a change in the price of the underlying asset. Then you have other factors such as the implied volatility. This is also a very important input in an option price and generally the higher the implied volatility, the higher the price of the option. It's only logical. A more volatile asset will demand a higher option price to make up for the risk in said asset. Then you have the time to expiry. This is also generally positively correlated with price. As the longer that you have to expire the more time value you have of the option. The sensitivity of the price of the option to the rate of change in time is called “theta”. This time value also makes sense when you think about it. The longer you have till the expiry of the option, the longer the time period in which the option could either be in or out of the money. These are just some of the main factors that will impact on the price of an option and they are perhaps the most important for you to understand if you want to trade them.
It’s time to explore how to use the option data to infer market trends and sentiment. Firstly I want to discuss the put call ratio. This is a measure of the ratio of the open interest or the volume of the puts, versus the calls. The open interest is a measure of the total amount of notional outstanding on a futures or options position. The volume is of course the total amount of options or futures that have been traded in a certain period. For example if we're talking about the open interest put call ratio, we're measuring the total notional outstanding value of all puts to that of the notional outstanding value of all calls. So what can we read from a put call ratio? Well it's able to give us a rough idea of general sentiment in the market. If there is more open interest outstanding for puts than calls, then that means there are larger bearish bets than bullish bets. Hence, a put call ratio of greater than one is viewed as more bearish than a ratio of less than one and vice versa. You can also view the put call ratio through time to get a feeling for how this broader market sentiment has changed. The ratio is slightly more than one when viewed with the volume metric and less than one when viewed with the open interest. I generally tend to use the open interest metric as this gives a more reliable indicator of outstanding trades than the total value of all the options being traded. So based on a put call ratio of 1.36, it means that the put option open interest is about 36% more than the corresponding call notional outstanding. On balance option market participants have more puts outstanding than they do calls. You may be wondering why is this relevant? Well, knowing how options traders are positioning themselves can give you a rough idea of which way they expect the spot market to go. And you should not really be fixated on the absolute number of the put call ratio but rather on how it moves. Whether it's increasing or decreasing, this can help give you a better sense of how that sentiment is changing. okay That's the put call ratio. Of course all this gives you is an overview of how the broader market is positioned. It doesn't really allow us to get a direct comparison in the pricing of puts or calls. This is where the option skew comes in.
