Credit: Shutterstock photoThe recent spike in market volatility has many investors on edge, leaving quite a few traders unsure how best to handle the situation. First of all, obey the golden rule and don't panic. Second, take a calm, rational look at your portfolio's holdings and determine whether or not your positions have breached any key support or resistance levels. These areas are important, as they can help you decide whether to close out your position, or hold out for higher levels.
Round numbers like $10, $20, $30 are quite popular support/resistance areas cited by technical analysts, as well as 10-unit (day, week, month) and 20-unit moving averages. However, one of the best sources for identifying these regions is often overlooked: option open interest.
Options-Related Support and Resistance
Large call open interest can often act as options-related resistance , especially at slightly out-of-the-money strikes among shorter-dated options. For example, let's assume that you purchase an ABC June 40 call, with the 40 strike already home to peak call open interest in the front-month series.
On the other side of that trade are the option sellers, who must purchase shares of ABC in order to offset their position. As the stock approaches the 40 level, the option writers will begin to unwind their hedges in order to remain delta neutral, thus applying pressure to the underlying shares.
Meanwhile, heavy put open interest can often act as options-related support . This is also partially due to the dynamics of options hedging, as traders sell puts in order to minimize exposure to risk and remain market-neutral.
In order to balance their sold positions, put writers might sell the underlying stock short. When the options expire or when the put buyers unwind their positions, the short interest on the equity will ultimately be repurchased, which can add to the buying pressure as the underlying shares approach noteworthy strikes.
However, not all "heavy" open interest will translate into support or resistance. To gauge if a particular strike is likely noteworthy enough to impact the charts : first, tally the number of open contracts at that strike; then, multiply that number by 100, as each contract represents 100 shares of the underlying stock; finally, if that number of shares represents at least 10% of the security's average daily trading volume, the strike could play a technical role going forward.
Furthermore, the effect of options-related support and resistance tends to be more evident among shorter-dated options . Since the aforementioned investors usually want their hedged bets to expire worthless, they'll typically follow the stock's price movement more closely as options expiration approaches. For example, if a trader bought an October-dated protective put on ABC, he's likely going to worry less about his position in July than, say, early October.
Finally, round-number levels are especially more likely to act as options-related support and resistance. Investors generally view these psychologically significant levels as good closeout points for short positions, meaning they're more likely to sell when the shares get to $90 or $100, than, say $83 or $107. On the other hand, traders tend to view round-number levels as good entry points for long positions, meaning they're more prone to scoop up a stock after it's fallen to $30 or $40, compared to a pullback to $27 or $59.
Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
