I am trying to understand if my thinking is correct or not.
I am looking at a stock that is @ $10.00.
When I look at the options on the stock $11, $12... calls are all down today and $11, $12... puts are up today.
Does this options action signify the stock is headed lower due to short interest in it overwhelming long and pushing stock price down?
If not then what does it mean?
Options reflect expectations about the underlying asset, and options are commonly priced using the Black-Scholes model:
N(d1) and N(d2) are probability functions, S is the spot (current) price of the asset, K is the strike price, r is the risk free rate, and T-t represents time to maturity. Without getting into the mathematics, it suffices to say that higher volatility or expectation of volatility increases the perceived riskiness of the asset, so call options are priced lower and put options are priced higher.
Think about it intuitively. If the stock is more likely to go downwards, then there's an increased chance that the call option expires worthless, so call options must be priced lower to accommodate the relative change in expected value of the option.
Puts are priced similarly, but they move inversely with respect to call option prices due to Put-Call parity. So if call option prices are falling, then put option prices are rising (Note, however, that call prices falling does not cause put prices to rise. The inverse relationship exists because of changes in the underlying factors and how pricing works.)
So the option action signifies that the market believes the stock is headed lower (in the given time frame). That does not mean it will go lower, and option traders assume risk whenever they take a particular position. Bottom line: gotta do your own homework!
Best of luck.
Options are an indication what a particular segment of the market (those who deal a lot in options) think will happen. (and just because people think that, doesn't mean it will) Bearing in mind however that people writing covered-calls may due so simply as part of a strategy to mitigate downside risk at the expense of limiting upside potential. The presence of more people offering up options is to a degree an indication they are thinking the price will fall or hold steady, since that is in effect the 'bet' they are making. OTOH the people buying those options are making the opposite bet.. so who is to say which will be right. The balance between the two and how it affects the price of the options could be taken as an indication of market sentiment (within the options market) as to the future direction the stock is likely to take.
(I just noticed that Blackjack posted the forumula that can be used to model all of this)
To address the last part of your question 'does that mean it will go lower' I would say this. The degree to which any of this puts actual pressure on the stock of the underlying instrument is highly debatable, since many (likely most) people trading in a stock never look at what the options for that stock are doing, but base their decision on other factors such as price history, momentum, fundamentals and recent news about the company. To presume that actions in the options market would put pressure on a stock price, you would need to believe that a signficant fraction of the buyers and sellers were paying attention to the options market. Which might be the case for some Quants, but likely not for a lot of other buyers.
And it could be argued even then that both groups, those trading options, and those trading stocks, are both looking at the same information to make their predictions of the likely future for the stock, and thus even if there is a correlation between what the stock price does in relation to options, there is no real causality that can be established. We would in fact predict that given access to the same information, both groups would by and large be taking similar parallel actions due to coming to similar conclusions regarding the future price of the stock.
What is far MORE likely to pressure the price would be just the shear number of buyers or sellers, and also (especially since repeal of the uptick rule) someone who is trying to actively drive down the price via a lot of shorting at progressively lower prices. (something that is alleged to have been carried out by some hedge fund managers in the course of 'bear raids' on particular companies)
Option prices can predict the range of movement of the underlying, but not if the underlying is going up or down.
An option price gives an implied volatility for an underlying . That IV number helps predict a range for the underlying price over the next few days,months, upto a year.
