Awaiting a "Spike-Peak Buy Signal"

By Lawrence G. McMillan

(Barron's) - Options can be great contrary indicators.

Puts and calls are very versatile. Strategically, they can be used for leveraged speculation by some, while providing protection, income, or both, to others. Their prices and volume also can produce information advantageous for an investor or trader, even if that person doesn't actually buy or sell options.

Contrary indicators monitor the activities of the masses. When most of the horde is doing the same thing—say, buying at all-time highs—a contrary investor will look to do the opposite. That's because the majority is wrong at major turning points, both tops and bottoms. (During the trend, most investors are correct; they are wrong only at the extremes.)

Option volume can be expressed as a put-call ratio (the number of puts traded, divided by the number of calls traded). Option prices, on the other hand, are expressed in terms of implied volatility—the component of an option's price that expresses the market's expectations for the volatility of the option's underlying security. Simply stated, the more volatile that the underlying instrument is expected to be during the option's life, the more one will pay today for the options contract. The most popular measure of implied volatility is the VIX, the Chicago Board Options Exchange's Implied Volatility Index...

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