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Sunday, September 14, 2003

While the CBOE put/call ratios were generally higher this week than last, this week’s R.O.B.O. put/call ratio^TM came in at 0.44, the lowest ratio in nearly a year and a half.  This highlights a growing disparity in the put/call ratios which I believe is being overlooked for the most part. 

The entire point of the put/call ratios is to isolate the emotion and buying power of those who are typically most often wrong on market direction.  That’s why they tend to be effective – options are wasting assets and have a high degree of leverage, so those who trade them usually have very definite opinions about their stocks.  The trouble with traditional volume or dollar-weighted put/call ratios has always been that we don’t know if traders are buying the options or selling the options, which is an issue the ROBO put/call ratio^TM  puts to rest. 

This week’s reading of 0.44 means that traders who spent of average of approximately $200 - $2000 on their trades of 10 contracts or less – the very smallest of options traders – bought to open 2.3 calls for every put.  As I’ve stated previously, when these small traders buy a call, it is for one reason and one reason only – they believe their stock is going to go up, and soon.  They buy a put because they fear it will go down, likely sometime in the next 30 days (in my experience, retail traders concentrate their activity in the next two expiration months – the ones with the most sensitivity to movements in the price of the underlying stock). 

Even more telling is the strategies employed by these traders.  Last week, 37% of opening transactions were call buys, 30% were call sells, 16% were put buys and 17% were put sells.  Last week, the amount of call buying and call selling were roughly equal, but this week call buying is the clear favorite and to an extent not seen since the year 2000.  The emphasis on bullish options strategies has been matched during only two other weeks since the bubble burst – June 15, 2001 and December 14th, 2001.  A three-week moving average of bullish strategies versus bearish strategies shows bullish strategies edging out bearish for the first time since 2000.   

Call buying has increased 44% from the week ended 8/29, by far the largest increase in activity among these traders, as opposed to a gain of only 5% for call selling.  It is evident from this that these traders are attempting to capitalize as much as possible on further upside (by buying calls), and they are not content to sacrifice any potential gain from their existing long stock positions (by tempering their use of call selling strategies, which limits potential upside on the underlying stock position which “covers” the call option).  Because these are such small traders, I don’t think they are using things such as “stock replacement” strategies by buying calls.  I believe the great majority of it is just pure speculation.  It is apparent from this activity that speculative retail traders believe the bull market is back. 

In Commitments of Traders data for the full S&P 500 futures contract, commercial traders (those holding 1000 or more contracts) became a little more net short while small speculators became a little more net long.  Both changes are in the wrong direction if you’re bullish on the market, but they weren’t notably large.  My preferred way of looking at this data is through the stochastic indicators for each trader group.  A stochastic indicator simply shows where the current reading is compared to all others over a given time period – if it is 0, then the current reading is the lowest; if it is 100, then the current reading is the highest. 

For the COT data, I prefer to use a one-year stochastic.  So, I am looking at where the trader net positions are compared to the range they have been in over the past year.  As a demonstration of how powerful this type of analysis can be, let’s go through the following tables.  These tables show the performance of the S&P 500 since 1986 after different stochastic readings for both trader groups. 

First, we will look at how the S&P 500 performed after the one-year stochastic for commercial traders reached 100 for two consecutive weeks.  This means that commercial traders were currently the net longest they had been at any other time over the past year for two weeks in a row.  In the tables, “AVG RET” refers to the average return in the S&P 500 the given number of weeks after the reading; “% POS” shows the percentage of time the S&P 500 was higher than it was when the readings were given; “MAX” refers to the largest gain in the S&P 500 the given number of weeks later; and “MIN” shows the largest loss.  

We can see that out of the 9 instances where commercials were at their net longest two weeks in a row, the S&P showed very positive performance beginning 4 weeks later.  When we go out three months (12 weeks in the table), the S&P was higher 89% of the time, with an average return of 6.4%, and a large 15.6% maximum gain and only a 2.0% maximum loss (please note that this does not equate to drawdown, it only refers to the close the given number of weeks later). 

Next, let’s see how the market performed at the other end of the extreme – when commercial traders were their net shortest for two weeks in a row. 

Quite a difference from the table above, and the reason why I think this information can be so vital to incorporate into your decision-making process.  Here, we can see that the S&P had great difficulty in making significant strides to the upside when these large traders were so negative on the market.  Not only was the average return negative across all time frames, but the market was negative a majority of the time.  Most telling, the maximum gain was dwarfed by the maximum loss. 

Now let’s look at the other trader group that is consistent with their market calls (consistently wrong, that is).  Small speculators are the “catch-all” group after commercial traders and large speculators have been identified by the CFTC, the regulatory body that oversees most futures markets.  Small specs do incorporate some relatively large traders such as hedge funds and the like, so it cannot be considered a “pure” contrary category, but it still works as a contrary indicator as the tables below illustrate.  This first table shows how the market performed after this group of traders was so positive on the market that they became their net longest of any other time over the past year, for two consecutive weeks. 

Not surprisingly, this looks very much like the table above where commercials were the net shortest they had been over the previous year.  Part of the reason this is so is because futures trading is a zero-sum game – for each buyer there is a seller; as one gains the other loses – and usually the two groups are trading to each other.  So, as commercials were becoming net short, small specs were becoming net long, and after these extremes were reached, the market had great difficulty afterwards. 

It shouldn’t be a great surprise then to see that when small specs where the shortest they had been in a year, it corresponds quite closely to the first table we looked at, where commercials were their net longest. 

Obviously, the market performed extremely well after such displays of pessimism from these small traders.  When small specs were the net shortest they had been over the past year, for two weeks in a row, it proved to be an excellent buy signal for the S&P 500. 

The next logical step would be to combine the two groups and see how the market performed after commercials were their net longest AND small specs were their net shortest.  While the occurrences usually occur close to each other, it has been relatively rare to see both occurrences happen at the exact same time, so there aren’t a whole lot of instances to look at.  In any event, the table below shows how the S&P 500 did after the most bullish configuration possible – commercial traders at “100” and small specs at “0”, both for two consecutive weeks. 

We only have 2 instances here, so statistically the results are pretty much meaningless.  However, for what it’s worth, we can see that the market did perform as expected by having a very positive bias after this type of activity. 

At the other extreme, when commercials were their net shortest and small specs their net longest, the market, as should be expected, usually had difficulty in making great strides: 

As of this week, commercial traders have been at “0” for two consecutive weeks, so the second table we looked at comes into play.  Small specs have been at or just above “90” for two weeks in a row now, so we’re not quite able to use the tables above for that group.  They would need to add about 10,000 more contracts to their net long position in order to reach “100” at this point, so that is something to keep our eyes on (all applicable charts are of course updated on the site each week). 

Large traders (such as the commercials as outlined above) and those better at market timing (such as OEX options traders) are quite negative on the market, while those who are on the opposite end of the spectrum are somewhere between largely and excessively bullish.  With the larger market structure being positive in my opinion, I don’t believe what we’re seeing is quite enough to be positioned aggressively against (i.e. short) the market at this point.  Obviously, we could have already changed trend again and be heading down, but I don’t think that’s particularly high-odds at the moment.  On Wednesday, I said that if the market could not stage something of a rally off the short-term oversold readings we saw, then that would give us a good clue that the character of the trend was beginning to change, but we did rally modestly so I don’t think we can read too much into that as far as potential trend changes go.  If we can rise back closer to Monday’s highs and begin to fail, or if we stay consistently under 1015 (raising the potential that the breakout last week was false), my opinion may change, but right now I am continuing to give the uptrend the benefit of the doubt.

 - 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.

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