Thursday, February 6, 2002 8:00 PM EST
I received a lot of questions about today's put/call ratio, so I want to relay the sentiments of Jon Najarian, a CBOE market maker and author of How I Trade Options. According to Jon, the huge put volume we've seen not just today but over the past several days is due to an offshore hedge fund that has created what appears to be a bullish put spread in QQQ options. This spread involved selling deep in-the-money put options and buying a similar number of options with a lesser strike in the January 2005 expiration series. The apparent underlying intention was to create an overall bullish position. This one trade was so large that it accounted for anywhere between 50% - 100% or more of average daily equity put volume. QQQ options are considered equity options, and so they are counted in the equity put/call ratio. The actual size of the trade varies by source, but if we back out a range of probable values, today's adjusted equity put/call ratio would likely be between .70-.85. The question now becomes - do we officially adjust the put/call ratio to discount the effects of this trade? I believe not, and will not modify the final total figure from the CBOE. The reason is because if we adjust for this one trade, then we have to go back over every other day and adjust the figures for what we can guess are institutional orders. Since they break up their orders, this becomes difficult if not impossible. If we start messing with the underlying data, I think that starts us on a slippery slope and I will not do it. I may discount the impact of the ratio on a discretionary basis, but that's as far as I'm going to take it.
That said, today's record-high equity p/c ratio has pushed the 10-day average well past its upper standard deviation band and on a par with readings only seen near short- to intermediate-term lows during this bear market. The last six times the average has exceeded its upper trading band since 2000, a rally of at least 30 S&P 500 points followed an average of 8 trading days after the 10-day average peaked. Please note that a peak in the 10-day p/c ratio only rarely exactly coincided with the market low. As I said, the market trough occurred an average of 8 trading days after the put/call ratio peaked. In order for the 10-day average to peak tomorrow, we'll need to see an equity p/c reading under .55, which would be on the low side and most likely only occur with a substantial market rally. This is not a precise timing device, rather a notification that the activities of equity options traders has reached a point that normally means the bets are skewed too much on the short side.
One indicator I haven't mentioned much (mainly because it hasn't done much) is the VIX Fear Premium. This indicator is a 10-day average of the excess of the daily VIX high over the 30-day historical volatility of the OEX. That's kind of a convoluted way of saying it shows how much fear, or more precisely, uncertainty, is currently priced into the market. When the indicator is high, then the VIX is showing a large premium to actual historical volatility over the most recent 30 day period. When it is low, then it shows that options traders expect lower future volatility than past volatility. If it is at exactly 0, then options traders expect the market to show the same volatility going forward as it has in the past. Usually, expectations of future volatility will climb higher as uncertainty mounts. And uncertainty increases when prices have fallen dramatically and traders are unsure of where it will stop. When this uncertainty reaches a crescendo, we are almost certainly near a tradable market low. The current reading of the VIX Fear Premium is 14, which means that over the past 10 days, the high of the VIX has been, on average, 14 points higher than actual volatility over the past 30 days. This puts it just under its upper standard deviation band of 16. However, because of the tremendous swings in volatility we've seen over the past year, the standard deviation bands around this indicator are the widest they have been since after the crash in 1987, so it would be very difficult for the indicator to exceed that band unless we enter a crash-like market environment.
The thick vertical lines below shows each instance since 1998 where the premium peaked over 14:
We can plainly see here that each occurrence coincided with a tradable low point. This suggests that the uncertainty currently being exhibited by options traders is excessive and should be wrought out by higher equities prices soon.
Our longer-term breadth measurements are also beginning to enter extreme territory. The charts below show the 21-day averages of the advancing issues ratio and the up volume ratio. The thick horizontal line on each chart represents our current reading.
We can see here that once again, we are reaching a point that has often coincided with intermediate-term rallies in the past, as most of the time the indicators made a trough below our current level, a rally soon followed.
The evidence is beginning to come in that we are approaching an intermediate-term low point. The excessive short-side betting as exhibited by the put/call and Rydex ratios, oversold breadth measurements, and excessive uncertainty (VIX Fear Premium) are all signs that a low is close. However, we have not yet seen other signs that typically accompany these lows. For example, the number of lows on the NYSE is just over 100. We normally see something closer to 700, or at least 200-300 for lesser lows. Also, neither volatility nor volume has been picking up as they should. Most of the sentiment surveys continue to lack an appropriate level of bearishness, and commercial traders have not been aggressively paring their short S&P futures positions. These points suggest that any bounce we get now will likely not last very long. About the only conclusion I can glean from these conflicting indications is that if we do begin to rally, it could be extremely fast and sharp, as those short bets are covered. However, we have not reached a place where most good multi-week rallies have been born, so if that explosive rally occurs, it'll probably fail quickly.
Bottom line: I think the chances of a quick multi-day rally are now high, but until we see further downside, it probably wouldn't last. I would trade that rally, but with a short time frame and tight stops. If we instead continue to drift lower, I will begin to look for some of the missing pieces I outlined above. If we get them, I would look for the first signs of a price recovery to accumulate long positions for a multi-week trade.
Disclosure: no positions
This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.
Tuesday, February 4, 2003 8:00 PM EST
The past two days of a mixed market has not changed our situation materially from where it was in the weekend commentary, so there's really nothing new to say this evening.
Short-term, we saw a little spike in down-side bets this morning, enough to once again bring the STEM.MR model into positive territory above its upper standard deviation band. The choppy rally throughout the rest of the day served to bring it back to neutral, however. This type of environment, where no trend lasts more than a day, is ideally suited to the shorter-term overbought/oversold measures like the price oscillators. These indicators have done a decent job at identifying the extremes over the past week. At one point, like all oscillators within a trading range, they will fail miserably as a new trend takes over, but until then I think it pays to heed their message when an extreme is reached. Currently, they are neutral for the S&P and NDX.
As I stated this weekend, the equity put/call ratio is finally beginning to show some signs of life. The 10-day average has jumped from .66 on Friday to .73 today, which is where it was on December 16th. We are quickly approaching the upper standard deviation band here, which is at .77 currently. If we see enough equity put volume to reach that level, it would be another very positive indication that retail traders had reached a pessimistic extreme.
The Rydex funds have now entered bearish extremes (bullish to us) across all time frames. I discussed these funds in depth this weekend, but I want to show the composite chart of the longer-term bullish and bearish flows. Bullish flows are in green and bearish flows are in red. The horizontal dotted lines show where we are currently. The two black circles show the only other times in the past two years where the flows had reached a comparable level of pessimism.
You can see that each time lead to a significant advance in the intermediate-term. While these flows can continue to become even more extreme, of course, it behooves us to be aware that there is a huge short bet that has been placed, and the first signs of a meaningful recovery could ignite some upward momentum.
We remain in a black hole where things are neither good enough nor bad enough to prompt large-scale buying. There has been heavy public shorting activity recently (extremely heavy in the case of the Rydex funds), and at some point that will result in a relentless, multi-day move up. The key question of course is from what level that will happen. I continue to believe that right now, the possible risk of further price declines does not justify the probable reward on that bet. If we can break down out of this range we've been in for a week, then we will be much closer to that point. So until we either move appreciably higher or lower, I'm neutral to slightly bearish and not pressing any bets.
For those of you who trade the S&P e-minis, please be aware that the late spike this afternoon was due to a Globex error. All trades filled above 860 will be busted, and new stop orders will have to be placed. Please be sure to check with your broker if you have any outstanding orders.
- Jason Goepfert
Disclosure: no positions
This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.
© 2003 Sundial Capital Research, Inc. All Rights Reserved.