Aug 31, 2003

Some of you may be tired of hearing about put/call ratios, but I urge you to concentrate on the first few pages of this note. I think it’s important to know what’s going on and what this staple of sentiment indicators is suggesting. This is one of those very rare times when a sea change is occurring in a widely-followed indicator, and we have the tools to properly correct for it.

The core put/call ratio – the one that’s most widely quoted – is the total put/call ratio from the Chicago Board Options Exchange (CBOE). By “total”, I mean that both equity options (i.e. options traded on individual stocks) and index options (i.e. options traded on index products, like the OEX or BKX) are included. In the past, this has been fine. The CBOE accounted for a good chunk of the option volume, and there weren’t too many distortions of the data by large institutional trades. On Wednesday, I went over the increasing influence of QQQ options, so I’m not going to belabor the point. But it should be noted that on Friday, there was a large number of puts traded, driving the total put/call ratio to a sky-high 1.29 reading. Fully 45% of those puts were due to a single trader in QQQ options. When we take out QQQ options, the put/call ratio drops to 0.75 – a decline of 42%.

Some have said that I’m rationalizing a bearish outlook by manipulating the data this way. A year ago, I would have agreed with them. But there has been a constant bombardment of large institutional trades in QQQ options, and as long as we can separate out those trades and analyze them separately, there is no harm done. The only harm would be to discount individual days based on a whim. When we can go back and observe the data both with and without those options, it is not rationalizing, it is analyzing and not taking common wisdom at face value. It’s the same exact thing as looking at the new high list with non-operating companies removed.

At this point, the total put/call ratio has minimal value. I’ve discussed many times recently why QQQ options have limited predictive power, so any ratio that includes them is not all it could be. By far, my preferred put/call ratio is the equity-only put/call ratio with QQQ options backed out, which is posted each day to the site. Currently, that indicator is coming off of a bearish (for the market) extreme that I pointed out last week, and is still at the lower end of its range.

Even if we look at the equity-only ratio with QQQ options removed, we are missing what could potentially be some very important information:

Fortunately, there is data available that will help us to answer each of the questions above.

The CBOE is only one of the exchanges where options are traded. There is also the American Stock and Options Exchange (AMEX), the Philadelphia Stock and Options Exchange (PHLX), the Pacific Exchange (PSE), and the new kid on the block, the electronic International Securities Exchange (ISE). Each of these exchanges owns an equal share of the Options Clearing Corporation (OCC), which is an organization that exists to handle the issuance and clearing of the options that are traded on the exchanges. The OCC has several specific functions, but basically it is there to make sure that everything runs smoothly and uniformly. If any of you have traded options before, you or your back office should have received a little informational booklet in the mail from your broker. That booklet came from the OCC.

Because the OCC clears the trades from each of the exchanges, it has an enormous depth of data on what goes on at each, some of which it releases to the public. For example, for the month of July, the CBOE accounted for 26% of the transactions, AMEX did 23%, PHLX did 12%, PSE did 10% and the ISE did 29%. Notice that last one – the ISE, formed just a few years ago – now accounts for more trading volume than does the CBOE.

This is where it gets interesting, and extremely useful. The OCC also breaks down the volume coming from the exchanges by trade size and type. Meaning, it tells us how many trades there were of 1-10 contracts, 11-49 contracts, and 50+ contracts. For each of those size categories, it also outlines how many calls and puts were traded, along with whether they were bought to open or sold to open. This is the crucial information from question #2 above, and it allows us to narrow our focus to a specific group of traders. This information gives us the power to truly isolate the smallest of traders, and determine what their strategy is. It doesn’t get much better than that from a contrarian’s perspective.

The OCC releases these figures weekly, for the week just passed. The report that was released yesterday (Saturday, August 30^th) covers the period from Monday, August 25^th through Friday, August 29^th so fortunately we don’t have to deal with much of a delay in reporting. For last week, the OCC reports 10.5 million equity option contracts as having cleared (this is counting customer trades only, and not firm or market maker trades). If we look at the numbers from the CBOE, they reported 2.9 million equity contracts. This is about 28% of the total, and is right in line with their recent share of the volume.

CALLS – 58% of Total
1-10 CONTRACTS	11-49 CONTRACTS	50+ CONTRACTS
23%	22%	55%
PUTS – 42% of Total
16%	17%	67%

We can see from the table that calls accounted for 58% of total trades. The very smallest of traders, those trading between 1 and 10 contracts at a time, accounted for 23% of that call volume, while larger traders of at least 50 contracts accounted for 55% of the volume. On the put side, small traders made up only 16% of the volume, while larger traders made up 67%. So already we can see that small traders were significantly more active on the call side than the put side, completely contrary to what the traditional CBOE put/call ratio would suggest.

Let’s focus in on those small traders and try to get a better feel for what they’re trying to do. When looking at put/call information, it is most helpful to see if the volume is going into opening transactions or closing transactions, as it will tell us how aggressive the traders are on betting on a market move. Also, especially for very small traders, buying options to open is more telling than selling options to open. A small trader buys a call option to open a position for one reason – he thinks his stock is going higher. He buys a put option to open because he thinks his stock is going down. You may argue that he’s trying to hedge some underlying stock position, but it doesn’t matter. If he thinks his stock is going up, he’s not going to buy a put just for shits & giggles.

If we isolate the trades to just those of 10 contracts or less, and further restrict it to buys and opening transactions only, we can get a true picture of what retail traders (i.e. small brokerage firm customers) are doing. The average premium per contract for these trades last week was $190, meaning the trade sizes were somewhere between $200 - $2000 on average. Because these instruments are so leveraged and decay with time, it gives us an excellent feel for the emotion and level of conviction in the market by those who, sad to say, are the most likely candidates in the entire market to lose their money.

Last week, small traders bought to open 695,000 equity contracts. Of those, 453,000 were calls and 242,000 were puts (I’m rounding here to make it easier to read). This gives us a “pure” put/call ratio of 0.53. I’m going to call this the Retail-Only, Buy-to-Open put/call ratio, or R.O.B.O. for short. Let’s put it into perspective:

We can see that at the height of the bubble, retail traders were going crazy over call options. For the week ended April 7, 2000, they bought to open 1,380,000 calls and only 237,000 puts, for a put/call ratio of 0.17. They were so delirious with lust that they were willing to pay an average premium of $814 per call contract to be in the game. They paid an average of $599 at the time for their puts. So they were buying nearly six times as many calls as puts, and paying 36% more for the right to do so. At an opposite extreme, the week ended October 11, 2002, they bought to open 430,000 calls with an average premium of $182. During the same week, they bought 508,000 puts for an average of $250. So they were willing to pay 35% more for protection than they were for potential upside – the opposite of what they were doing during the bubble.

During the latest week, retail traders paid an average of $179 for puts and $213 for calls – they’re now willing to pay 20% more for calls than they are for puts. And as you can see from the chart above, they have been busy buying calls and ignoring the protection of puts for two months now. They have been doing this at a pace seen only four other times since the bubble burst, and it lead to declining prices each time.

Now let’s take a different approach and look at how they are trading their options as a whole. Last week, these small traders opened a total of 1,460,000 contracts. Here is the distribution of their priorities (opening transactions only):

Remember, we’re talking about very small traders here, so the vast bulk of the trades are not going to be a part of some complicated options strategy. Generally, if they buy a call, that means they are bullish, but if they sell a call, they are either less bullish or relatively bearish on the stock. If they buy a put, they are bearish but if they sell a put, they most likely believe the stock is going up, or at least not down a lot. Out of the 1.46 million contracts they opened, retail traders split their strategies fairly evenly among those that are bullish compared to those that are bearish. On the surface, that seems as though it may conflict with the R.O.B.O. put/call ratio, which was very clearly skewed to the bullish side. However, these strategies are more skewed to the bullish side than average over the past two years, as the chart below shows.

Selling calls (most likely against an underlying stock position – a covered call write) has long been a popular strategy for these traders. In fact, when they buy more calls than they sell, the market has usually dropped afterwards. You might look at this chart and say “hey, wait a minute…you’re calling these guys the ‘dumb money’, but they’ve been concentrating on bearish strategies for two years while the market has tanked…this is the SMART money!”. Well, not really.

The reason the strategies are skewed so greatly to the bearish side is because call selling typically makes up about 40% of the volume (for opening transactions), by far the largest percentage of all the strategies. But these traders are almost always selling calls against an existing stock position, not selling calls naked as an outright bearish bet on the market. Margin requirements on naked call selling are extremely high, especially for such small traders. In fact, as the former manager of a large margin department, I know for a fact that the great majority of these traders wouldn’t even be approved for naked call selling. So, yes, the strategies have been bearish overall for two years, but it is because they were trying to squeeze a little extra income out of their stocks, and not because they were outright bearish.

In mid-June, we saw these traders become excessively bullish, as the bullish strategies almost equaled the bearish ones, overcoming the effects of call selling (the green and red lines in the chart above almost met at 50%). As you can see from the chart, when the two lines have met in the middle, it lead to declining market prices each time. And when they became extremely far apart (meaning bearish strategies were swamping bullish ones), the market rallied each time. There is a lag in this chart, since I used a 3-week average to smooth out some of the extreme weekly fluctuations, but still it coincided with market turns fairly closely. While the spread has widened out in the past couple of weeks, when you look at the table above you can see that for the most recent week, the strategies were about even at 49% bullish and 51% bearish. While I wouldn’t quite call that extreme, it is certainly troublesome and we most certainly can’t suggest that these traders are even remotely bearish.

Speaking of retail traders not being bearish, the small speculators in the large S&P 500 futures contract reversed the change they made last week. You’ll recall that these traders reduced their net long position by about 13,000 contracts for the week through August 19^th. In the most recent report, covering trades through August 26^th, these traders reversed that drop and then some, as they added nearly 18,500 contracts to their net long position. Large commercial traders did the opposite, as they added 12,000 contracts to their net short position. Since the week ended July 8^th, when the S&P closed pretty much exactly where it closed this past Friday, commercials have added 25,600 contracts to their net shorts while small specs have become longer by 19,200 contracts. All of our derivative indicators, such as the stochastics and Futures Balance Matrix, are now bearish (for the market) across the board.

On August 19^th, I showed a 39-period sum of the intraday TICK on the NYSE. At the time, it was relatively overbought and suggesting that in the short-term at least, the potential upside was limited compared to downside risk. The choppy to declining market after that lead to a mild oversold reading in this indicator by early last week. Since that time, I have recorded 49 straight positive readings (taken every ½ hour), which has pushed the TICK indicator back close to +20,000. This equates to an average TICK reading of +500 every ½ hour for three straight days. The vast majority of the time, this is simply unsustainable. A current chart is below:

Besides the TICK readings, our other breadth measurements are also overbought. Up volume as a percentage of total volume, and advancing issues as a percentage of total issues, are both at the upper ends of their ranges. Our Down Pressure indicators for the S&P 500 and Nasdaq 100, which computes both the volume and number of points gained or lost for each of the component stocks of each index, are also solidly overbought. The VAB index (Volume Adjusted Breadth) that I mentioned on August 21^st (see the archives for reference) is still incredibly overbought at .73.

Breadth is overbought, small options traders are enthusiastic about the market and don’t feel a need to protect themselves to any great degree, specialists on the NYSE have picked up their shorting activity (though not to any extreme degree), commercial traders continue to get short the market, the sentiment surveys remain in historically negative (for the market) territory, Rydex mutual fund timers are again becoming quite optimistic, and seasonality is terrible. The market was also very overbought in May – not to the same degree as now, but overbought nonetheless – and it didn’t make any difference as we broke to new highs. If we are indeed in the midst of a prolonged bull market, we are facing another test now. If the broader market can break to new highs in the face of all these negatives, I do not want to be short and will instead shift my focus to the long side, at least for a short while, out of respect for the potential. When the market doesn’t do what it “should” do and has historically done, then that in itself can be a very telling sign. If we do break out to the upside, I want to have the utmost awareness for the potential of a false move, but as long as we hold that 1015 level, there should be fresh buying coming in. In the meantime, as long as the S&P 500 remains under 1015, I want to concentrate on the side of the market that has the most potential, and to me that is down.

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.