Longs Called Into Question
Monday, March 22nd, 2004 8:45pm EST
Put Down
Bottom Line: Our best measure of small-trader option market sentiment is not showing the type of scramble for protection we should expect.
One of the commonly-cited reasons to expect a bounce last week (including from yours truly) was the very high put/call readings we were seeing. The total p/c ratio from the CBOE, which includes both equity and index options, has now soared above 1.0 for five out of the past seven days – a level of put activity seen almost exclusively in the vicinity of market lows for the past 10 years.
If we winnow out some of the activity, however, we see a little less fear being shown. For example, if monitor equity options only, and we take out QQQ option volume – something that I think is imperative in order to remove institutional influences as much as possible – then the ratios were high last week, but not extraordinarily so. We saw one reading over 0.80, but no more. Compared to other recent intermediate-term lows, when we saw several days with readings well over 1.0, we have not seen the large-scale panic that we saw previously. Still, the ratios were high enough that they matched or exceeded readings we saw at other short-term lows since last March, so it was valid to watch for a similar thing this time around.
Even if we watch equity volume only, and even if we subtract QQQ volume, we are still left with a couple of major unknowns – who exactly is trading the options, and are they buying or selling them? This is where our ROBO put/call ratioTM comes in. Recall that the ROBO ratio stands for Retail Only, Buy to Open, and it is comprised solely of those trades of 10 options contracts or less (with total transaction costs typically between $200 and $2,000, so we know we’re dealing with the smallest of trades) and only those trades that are bought to open (as opposed to options that are sold to open, which have totally different risk/return characteristics). So if we can see how many puts were purchased versus calls for the very smallest of traders, then we can get a true feel for whether the high put/call ratios from last week were “accurate” as a contrary guide.
This data is released weekly, but on the plus side it is “real-time”, meaning there is no delay and we can see the figures for the week immediately past. When computing the data this weekend, I was fully expecting to see a spike in put buying as these traders attempted to take advantage of the decline as per their usual pattern. Instead, I was surprised to see that while they reduced their call purchases by 21%, they also reduced their put purchases by 13%. This moved the ROBO put/call ratio to 0.43, which is up from a low of 0.30 in January, but well below what was expected given the daily readings from the CBOE.
Below is a chart showing the extent of the activity since 2000 (and, of course, it is updated each week on the site):
We can see from the chart that clearly we are nowhere near an area where we could construe that these traders are showing excessive pessimism. They have been “right” for several months as their preference for calls has generally paid off. Still, I would feel more comfortable on the long side if these traders were betting more aggressively on the short side (via buying puts). The fact that these small traders continue to see no need for put protection remains a bearish indication for the market.
OK, THIS is the Last Time for the TRIN
Bottom Line: Once again, the TRIN is giving readings worth talking about as it has jumped to levels usually seen during crashing markets.
I said last week that I didn’t think I would talk about the TRIN again any time soon, but I feel I have to make an exception. Say what you will about the indicator (and I have), its current readings certainly beg attention. Today’s sky-high closing reading of 3.57 is the highest single-day reading we’ve seen since last March, and it served to push the 10-day moving average up to 1.89. That reading in the 10-day average is the highest it has been since the mini-crash in October 1997 (yes, even higher than the ones in 1998, 2001 and 2002). Prior to that? The crash in 1987. Prior to that? We would need to go all the way back to September 1955, when the market was suffering one of its first quick, severe pullbacks from recent highs after an extended bull run.
Since 1940, after any day that showed a 10-day TRIN reading of 1.75 or greater, the Dow Jones Industrial Average was higher 71% of the time 30, 60 and 90 days later, with average returns of 1.5%, 2.4% and 4.4% respectively. After six months, the Dow was higher a remarkable 86% of the time (145 out of 169 days), with an average return of 6.5%. Most of these days (114 of them) occurred in the 1940’s, so obviously it has been extremely rare to see such a high 10-day TRIN in the past 50 years.
If we just look at the 55 days since 1950 when the 10-day average reached 1.75 or higher, then the Dow was higher after 90 days 52 times (95% of the time), sporting an average return of 8.7%. The average gain was a hefty 9.4%, while the average loss was 2.3%. Speaking of those average losses, as I stated there were only 3 days out of 55 that showed a loss after 90 days. Two of those days were in early June 1962 when the market was accelerating its downtrend before forming a major multi-year low later that month. The other day that showed a loss was in early July 2002, when (once again) the market was in its acceleration phase before forming a major low later that month.
There certainly are arguments for ignoring these TRIN readings. In fact, I have recently shown that it may be more likely that we will see these types of readings in the future due to decimalization. But I also think that it is imperative to look at history, and the history of this indicator when it reaches these proportions is very good. The one caveat is that it has preceded waterfall declines on a few occasions, and so going fully invested on such precedent is not recommended. However, it suggests that if one has a timeframe of several months, the downside risk is becoming overwhelmed by upside opportunity.
Conclusion
I was asked several times if I give any weight to the fact that downside volume on the NYSE was more than 10 times that of upside volume today. The answer is “No, I don’t”. While such lopsided volume has been a good precursor to short-term relief rallies over the past few years, historically a single 10-to-1 day has not meant much at all. Sometimes they marked the exact low of an intermediate-term move, sometimes they preceded just a short-term snapback, and still other times they just begat more selling. If we would see multiple days in succession, then I would pay more attention, but a single day hasn’t had much significance in the past.
Our indicator scores and the Composite model are now giving off very bullish readings for the market. There is no question that we are extremely oversold according to many of our measures. The question, of course, is if oversold is enough. I don’t think so, at least not yet. I thought we would see more of a bounce off the extreme short-term readings we saw last week, but any move below those lows called everything into question. Today’s violation of those short-term panic lows has me on guard, and for the moment I have no desire to look on the long side of the market unless it’s either for an intraday trade or a very long-term position. Even for long-term positions, though, I think there will be better risk/reward opportunities than now. If we can rally back up through last week’s lows, then I may be tempted to look long once again, but ideally that type of reversal would have happened today. As it stands, while it would not be at all surprising to see a quick relief rally after today’s lopsided performance, I’m not seeing the type of activity that I would prefer to see to feel that the risk/reward heavily favors the long side on any time frame.
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
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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