Also a list of 25 stocks that are likely to outperform based on this indicator
One of our better known indicators is the Schaeffer’s Open Interest Ratio (SOIR). The SOIR only takes into account open interest in the first three months of expiry and is the number of puts divided by calls. We also look in detail at the gamma-weighted SOIR, in which we weight the open interest depending on the gamma of the option. Below I’ll explain why we’re doing this and show the power of using gamma-weighted SOIR as an indicator. Then I’ll leave you with a list of stocks to consider for short-term trades.
What is gamma?
Since this is not meant to be an article about option Greeks, I will only briefly describe gamma and how it is relevant to our indicator. The Greeks are used to quantify how sensitive an option is to certain variables. Delta is a number that describes how sensitive the option price will be to changes in the underlying asset, while gamma tells an options trader how much the delta will change.
To understand why we use gamma, just look at the graph below, which shows the gamma of an option as a function of its strike price. An option at the money (ATM) has a very high gamma. The further away the exercise price is from the share price, the smaller the gamma.
For the gamma-weighted SOIR, we multiply the option’s gamma by its open put interest and then by the option’s open call interest. If we divide the gamma weighted puts by the gamma weighted calls, we get the gamma weighted SOIR. This indicator gives higher priority to open interest that is near the money and ignores open interest that is either deep in the money or deep out of the money.
Theory behind the indicator
High gamma options are relevant for several reasons. First, options with strikes near the money in general have recently been added and convey the latest sentiment regarding a stock. A high number of puts on a stock indicates pessimism, which we believe has bullish effects.
The second reason has to do with the mechanics of market making. When a trader buys put options on a stock, the market maker selling the puts is exposed to a decline in the stock price. Therefore, as a hedge, he empties a certain amount of shares, which is determined by the delta of the sold puts. When the stock rises, it reduces the likelihood that its put options will be in the money and reduces its chances of cashing out on expiry. If the stock price rises, it will cover its short position, which will give the stock further tailwind. In other words, we would expect a high gamma weighted SOIR to be a bullish indicator.
Reliable indicators for gamma-weighted SOIRs
To test this indicator, I looked at the stocks in the S&P 500 Index (SPX) over the past year, or 52 weeks. Each week I found the stock returns from opening on Monday to closing on Friday based on the stock’s gamma-weighted SOIR, calculated using that Friday’s expiration date (and some liquidity criteria). I’ve grouped the 25 stocks with the highest gamma-weighted SOIRs and the 25 stocks with the lowest gamma-weighted SOIRs and summarized their returns.
As you will see below, this indicator has an impressive track record. The table shows the stocks with the highest gamma-weighted SOIRs that averaged 1.55% earnings each week, with 56% of stocks beating the S&P 500 that week. Stocks with a low gamma-weighted SOIR score earlier in the week averaged a modest 0.28% loss, with just 42% beating the S&P 500.
25 S&P 500 stocks with the highest gamma-weighted SOIRs
As promised, here are some stocks to consider based on the analysis above. The first table consists of the 25 S&P 500 stocks that have the highest gamma-weighted SOIR based on next Friday expiration. According to this study, they have a better chance of outperforming.
Finally, here is the list of stocks with the lowest gamma weighted SOIR. In the past year, stocks with low values tended to underperform.