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ubles。in price during a one…year period is。very likely to be the object of a fair amount of bullish sentiment simply because the gains。it has registered are likely to have attracted major attention among investors； because everybody loves。a winner。 Technical analysts。will be drawn to the stock。based on the notion that 〃the trend is。your friend〃 and even those with a fundamental bent will likely be swayed by the strength in the shares。and will tend to view the pany's。prospects。more positively。 And； as。technicians。well know； such a powerful move by a stock。often indicates。that there have been （or are about to be） some major positive developments。in the pany's business。 So the task of the contrarian in these situations。bees。the extremely difficult one of attempting to determine whether this。bullish sentiment has。reached a euphoric。extreme that indicates。a serious。depletion of sideline buying power and thus a potential top。
But if a stock。is。exhibiting strong price action and the sentiment remains。skeptical or outright bearish； the task。for the contrarian is。much easier。 Bearish sentiment bined with strong price action is。an unusual situation； indicating with great regularity that an uptrend in a stock。is。relatively。early in the game because there remains。major sideline buying power that can fuel substantial additional gains。
2。 A trader will have 〃structural buying〃 working for him because of the buildup in put open interest and its。subsequent unwinding。 When puts are accumulated on a stock； those who are on the other side of the trade （those who are selling these puts。to the put buyers） must protect themselves。from the open…ended risk。they'll incur should the stock decline substantially。 And they generally hedge their short put exposure by shorting the underlying stock。 But should a strongly performing stockntinue to post outsize gains； these short positions。will begin to be covered as。the put buyers。begin to capitulate and close their positions。 And even if the put positions。remain open； there will be short covering because the hedgers。need to be short fewer and fewer shares。as。the puts。they've sold move farther and farther away from the strike price and （as。time passes） thus have a smaller and smaller chance of ever attaining value。
Here are some detailed examples。of stocks。that exhibited outlier put open interest in bination with strong price action。 Figure 7。1 charts。the price action in AMR Corporation （AMR） along with the 50…day moving average of its。SOIR。 Note the powerful rally in AMR from late 2004 through mid…2005； along with the skeptical option trader sentiment as。reflected in the 50…day moving average of its SOIR as。it crossed above the 1。00 level （as。indicated by the horizontal line）。 This。juxtaposition of strong price action and bearish sentiment provided a very bullish backdrop for the shares。during this period。
The SOIR line crossed with authority above 1。00 in November 2001 and remained in this。zone until June 2006。 During this。period； AMR shares。rallied from the 9。00 area to a high of 29。32。 For more than eighteen months； while the shares were more than tripling； skeptical option traders。were accumulating more AMR put contracts。than call contracts。
In addition to the bearish sentiment of option traders； AMR was。being played very。heavily。on the short side in late 2004。 Short interest in excess。of 50 million shares。equaled almost 25 percent of the pany's。total float。 Although some of this。short interest could be attributed to the heavy put option buying； there was。a clear overall pattern of negative expectations for AMR shares。
When might a technician have felt fortable with buying AMR as。a bullish contrarian play； given this。backdrop of bearish sentiment？ Figure 7。2 charts。the weekly price action of AMR along with its。10…week。moving average and provides。a good backdrop for an answer。 The 40…week。moving average is。a widely used barometer among technicians。of whether a stock。is。in bullish or bearish territory。
Figure 7。2 indicates。there were a number of junctures。in late 2004 and early 2005 for entering an AMR long position based on a move above the 40…week。moving average。 Some of these moves。were followed by。pullbacks。that may have stopped the trader out； but an entry in the 9 to 10 area in late March 2005 or perhaps。an entry in October 2005 in the 12 area on the successful retest of the 40…week。would each have been quite legitimate。
Using a move back。below the 40…week。moving average as。an exit criterion； the trader would have exited in July or August 2000 in the 21 to 22 area。 So a technician trading AMR off the bearish sentiment could have achieved something in the area of a double based on a simple 40…week。moving average cross。criterion for entry and exit。
Figure 7。3 presents。a second example； which charts。the price action in Yahoo！ （YHOO） along with the 50…day moving average of its。put call open interest ratio （SOIR）。 The SOIR for Yahoo！ remained above 1。00 for most of the period from mid…2003 through the end of 2004； during which the shares。tripled from 13 to 30。 This。is once again a juxtaposition of strong price action and bearish sentiment； and it provided a very bullish backdrop for Yahoo！ shares。during this。period。 What's。more； Yahoo！ was。among the most heavily。shorted Nasdaq shares during this。period； with short interest in the neighborhood of 100 million shares。
Figure 7。4 charts。the weekly price action of Yahoo！ along with its。40…week。moving average and shows。the powerful uptrend in Yahoo！ shares。during the entire period of excess。put activity from mid…2003 through the end of 2004。 A contrarian trader could have felt fortable in entering a long position at the beginning of this。period and holding it for the entire 200 percent gain； but a few caveats。are in order。
Note in Figure 7；3 that the SOIR for Yahoo！ did move below 1。00 for several brief periods。 And although one could argue that Yahoo！'s strong price action would have been more than sufficient to justify retaining the long position in the shares； there was。the potential for a trader to exit the position based solely on the SOIR above the established
1。00 parameter。 Also； the shares。did move briefly below the 40…week。moving average in August 2004； although not on a weekly closing basis。 Again； there would have been the potential for a shakeout； but nonetheless at a very hefty profit level。
Immeasurable*
The put/call open interest ratio （SOIR） is。one of a number of ways。of slicing and dicing the information a trader can glean from the ebb and flow of option activity。 A put/call open interest ratio that's。a consistent outlier may indicate tradable extremes。in sentiment on a particular equity； but there are limitations。to the scope of what the ratio can measure。
The SOIR is。calculated using a ratio of put to call open interest for the three front expiration months。 A stock。may exhibit a very。high SOIR； but if the level of option activity on that stock。is。modest—relative to average trading volume or to share float—the significance of a high ratio of put to call open interest is。radically diminished and may in many cases。be of zero consequence。 This。option activity would be described as。being of 〃low intensity。〃
Option pricing would be yet another measure of the intensity of option activity。 Options are priced based on a probabilistic。model whose major inputs。include the share price； the strike price of the option； the time remaining until option expiration； and the assumed future volatility of the underlying stock。 Within a group of on…the…money options。（options for which the stock。price equals。the strike price） on various nondividend…paying stocks。with a mon expiration date； the differences。in option pricing levels。can be explained almost entirely by。the differing assumptions。for future volatility。
Although the assumed volatility （known as。implied volatility。among options traders） does。not coincide precisely with the recent volatility of each stock； it is。usually close enough so that the following example of how option prices。can vary more than suffices。 Hansen Natural （HANS） is。an energy drink。manufacturer whose stock。has。alternated between very。hot and very cold。 The wild gyrations。in the share price translate at this。stage into an annual volatility of about 70 percent。
Cisco Systems。（CSCO）； on the other hand； has。bee a steadily growing blue…chip pany in the technology。space with a market capitalization in excess。of 150 billion。 It is widely covered on Wall Street and widely held by institutional investors。 So it should be no surprise that the annual volatility of Cisco shares is。modest and in the neighborhood of 25 percent。
How do these varying volatilities。translate into the pricing of Hansen and Cisco options？ A three…month； on…the…money call option on Hansen would trade at approximately。14 percent of the share price； a similar option on Cisco would trade at approximately 5 percent of the share price。 In other words； the options。are priced in direct proportion to the assumed volatility of the underlying stock。
The Fear Factor
But volatility。assumptions。are constantly changing for even optionable stock。 Sometimes。this。is。simply the result of a change in the recent volatility of the stock。 Sometime