Is Main Street Catching on to Options?

Volume Clue

Stocks versus Options

Staggering Findings

A few weeks ago, I had the pleasure of going to lunch with Tim Lutts, the president of Cabot. Fortunately for me, Tim was in Miami for a conference and I didn’t have to travel up to the office in Massachusetts during the month of December!

During our lunch, we discussed the market and how pathetic the volume has been for stocks lately. Our conversation turned to options and whether there had been the same kind of drop off in volume. This simple conversation sent me down a path that led me to some pretty staggering findings.

After doing searches for volume data from the New York Stock Exchange (NYSE) and the Chicago Board Options Exchange (CBOE), I discovered that there is a major shift happening in the way investors view and use options.

Let’s start by looking at the volume on the NYSE. From 2005 through 2008, the average annual volume on the NYSE grew by over 10% per year. After the bear market from 2008-2009, the annual volume declined each year, with 2010 volume declining 19% from the 2009 volume. For the 2011 numbers, I used the average monthly volume for the first 11 months to arrive at a total for December in order to get a full year of data. As we enter the final week of trading, we are looking at another double-digit percentage volume loss for 2011.

Chart 1

What this suggests is that the average investor hasn’t come back into stocks at the level they were before the bear market. After dealing with two bear markets in less than 10 years, perhaps the average investor’s confidence is shaken and this is keeping them out of the market.

The next step was to look at the annual volume on the CBOE. Options trading grew by huge percentages from 2005-2008, with an average annual growth rate of 35% over the previous year. However, rather than declining sharply in the last three years, options volume declined by a much smaller percentage than stocks.

Chart 2

I have been trying to tell people for a number of years that options present a way for investors to participate in the market’s movements with far less money tied up in the market. Perhaps investors are starting to realize this and so options volume has been relatively stable over the last three years.

The final step in my analysis was to take the options volume and multiply it by 100 because each option represents 100 shares of the underlying stock. After taking this step, I looked at the options trades as a percentage of the stock trades. For instance, in 2004 there were 369.6 billion shares of stock traded on the NYSE, while 361 million options contracts were traded on the CBOE. In this case, the option volume multiplied by 100 came out to 36 billion shares of stock represented. The math from there is pretty easy as 36 billion is just under 10% of 369 billion. In other words, the amount of stock represented by options traded on the CBOE was approximately 10% of the NYSE’s stock volume.

So options trading grew faster than stock trading from 2005-2008 and then didn’t drop off as much in the last three years.

Chart 3

From the table above we see that the amount of stock represented by the options traded on the CBOE has increased sharply as a percentage of the stock traded on the NYSE. The number of shares controlled by options was just under 10% in 2004; in 2011, it’s estimated to be just under 30%.

Whether it is Main Street or Wall Street, investors have discovered that options present opportunities and strategies not available with stocks alone. With options, you can lower your total dollar exposure, but still participate in the market’s movements. You can use covered call strategies to add income to your portfolio or you can buy protective puts as insurance for your portfolio. But the view that options are only for risk takers is definitely changing and services like the Cabot Options Trader are becoming more sought out by investors. It has been 21 years since I made my first options trade and now more and more investors are realizing how options can play a part in their portfolio. It’s about time.

Good luck and good investing,

Rick Pendergraft
Editor of Cabot Options Trader

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