A Surprise Should Set the Tone
Thursday, April 1st, 2004 7:45pm EST
Taking out the QQQ’s
Bottom Line: QQQ options are greatly distorting the traditional put/call ratios, and looking at the data without them gives a less-bullish picture than appears at first glance.
A lot of fingers were pointing to yesterday’s put/call ratio as released by the Chicago Board Options Exchange (CBOE) as a sign of excessive pessimism. Yesterday the total put/call ratio, which includes all index and equity options, closed at 1.31 – the highest reading since last February, and one of the highest readings in the history of the data. However, a very large part of the “put” side of the put/call ratio was due to a trader in Nasdaq 100 Trust (QQQ) options. Put options on QQQ accounted for more than 50% of all equity put volume yesterday, which obviously skews the other ratios.
With so many puts being traded on QQQ yesterday, the put/call ratio for that instrument alone was over 19 (i.e. there were 19 puts traded for every call). This reading is the highest in the history of QQQ options and of course is by far the highest readings we’ve seen so far this year. But should we consider this a bullish or bearish development (or neither)?
The chart below shows the put/call ratio for QQQ over the past year. The huge spikes in the ratio are obvious on the chart. Something to note is that of the 8 times that the ratio became ridiculously skewed – like over 10 – nearly every one came within a day or two of month-end. Only one occurred outside of month-end, and that was in January of this year the day before expiration. This is not a coincidence, and it is further evidence that these are institutional products that are best left out of a contrary indicator. The arrows on the chart highlight those times that a 10-day moving average of the QQQ put/call ratio became very high (red arrows) or very low (green arrows).
Comparing the arrows on the chart to how the Nasdaq 100 performed afterwards, it should become clear why these options should be excluded from what is supposed to be a contrary indicator. We can see here that when the p/c ratio was low, the market most often rallied afterwards, and when it was high the market had difficulty. This is the exact opposite of what is supposed to happen, and it is the reason why I prefer to exclude them from other equity options when looking at the daily numbers released from the CBOE.
The chart below is a snapshot of the 10-day moving average of the equity put/call ratio after QQQ options are removed. The green and red bands are 6-month Bollinger Bands, which are included to help identify relative extremes in the ratio. When the indicator pops above the green band, that shows excessive put volume relative to calls and should be bullish for the market; a drop in the indicator towards the red band shows a preference for calls over puts and should lead to market weakness.
Looking at this option data this way has been fairly effective over the past few years. We can see that the indicator gave a “buy” signal a couple of weeks ago (around March 22nd) by poking above the green band, even though it never became extreme on an absolute basis, and has since declined back to neutral territory. Also note that even though I would now consider the reading neutral based on where it is in relation to the Bollinger Bands, its current value of 0.51 is comparable to what was seen at market tops up until the spring of 2003.
I’ve been asked why I don’t also exclude DIA options from the options totals, as once in a while there is sizable volume in them (DIA, or “Diamonds”, are a tracking stock tied to the Dow Jones Industrials Average). The reason is because DIA options are not considered equity options, while QQQ options are. Yes, both of them are index tracking stocks, but the CBOE treats them differently for reporting purposes – QQQ options are equity options, DIA options are index options. I don’t see the sense in it, but that’s their methodology.
While there are plenty of reasons to be bullish, I think it would be a mistake to include the put/call ratios among them. The total and equity put/call ratios that so many are talking about are being skewed by an institutional product that appears to also have seasonal influences, and when they are removed it is clear that options traders have not yet shown the scramble for put protection that they have at other major lows. This is confirmed by our R.O.B.O. put/call ratio of small-trader sentiment, and overall this data is more bearish to me than anything.
Conclusion
Last month, I went over some stats on how the market has reacted around the jobs report, which is released tomorrow. The day before the report has now closed in positive territory 11 out of the last 12 times, and it continues its pattern of having a relatively narrow range. After negative surprises in the report, meaning a payroll figure at least 20,000 less than expected, the market normally had a negative short-term reaction but was higher a majority of the time after 20 days. After positive payroll surprises, the market on average had a neutral initial reaction, but was an average of 2.3% lower after 20 days. Like I said then, it’s extremely difficult to extrapolate past responses to economic releases into the future, since the market is constantly re-adjusting what is considered “good” and what is “bad”. Still, I think it’s helpful to know that in the past the market has usually traded in the direction of the surprise in the short-term, but opposite the surprise after 20 days.
Last time I noted that I had no desire to be short as long as the S&P was able to hold above the 1125 level, but that I also didn’t see any decent risk/reward opportunities to establish long positions with the sentiment condition we had at the time. As I said above if the payrolls come in significantly higher or lower than expected I would generally prefer to trade in the direction of the surprise over the ensuing days. As of tonight, I am still in wait-and-see mode.
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.
© 2004 Sundial Capital Research, Inc. All Rights Reserved.