Flees to ETF Liquidity in Times of Uncertainty
Tuesday, May 18th, 2004 7:20pm EST
ETF Relative Volume – Nasdaq Edition
Bottom Line: Similar to volume in SPY versus the stocks of the S&P 500, dislocations between volume in QQQ and the stocks of the Nasdaq 100 tend to occur around market turning points.
In the last comment, I went over what has happened recently when volume in the S&P 500 exchange traded fund, SPY, was significantly different from that of the underlying securities in the index. The chart posted then was clear – unusually high volume flowing into SPY, over and above what was recorded in the underlying stocks, was a pretty good indication that a market low was close at hand. I received many requests since then to look at the same information for the NDX and its popular ETF, QQQ.
The chart below shows the same information as the one presented earlier for the S&P 500. To repeat, the blue line on the chart represents the difference between volume flows in QQQ versus the underlying stocks of the Nasdaq 100. “Volume flow” is simply defined as how current volume compares to its 50-day moving average. If volume in QQQ (compared to its 50-day average) is significantly higher than volume in the stocks in the NDX (compared to their 50-day average), then the line will be high. In the chart below, this volume difference is plotted as a 10-day moving average.
Similar to what we saw with SPY versus the S&P 500, high ETF volume appears to coincide quite well with periods of high uncertainty, which not surprisingly is often when the market puts in some sort of low. Conversely, periods of low volume in QQQ marked several of the short-term tops, with the best example being in January of this year.
Currently, QQQ volume compared to NDX component volume is running at its highest pace since at least 2002. Over the past 10 days, QQQ volume has averaged a 27% premium to the component stocks in the NDX (again, relative to their 50-day moving averages), which is slightly higher than what was seen in late March and early October 2003 prior to that, both of which marked nice upside reversals. I don’t want to get too much into why this may be, but my guess is that the ETFs offer such liquidity and ease of trading that individuals and large funds find it easier to flee to QQQ and SPY than individual stocks in times of great uncertainty. If that is correct, then these volume patterns should continue to be a decent guide going forward, and I believe it is worth monitoring on a regular basis.
OEX Traders Becoming Determined
Bottom Line: Today’s interesting movements in OEX options suggest those traders are becoming increasingly determined to have long exposure.
Unlike put/call ratios for equity options, which tend to be a good contrary indicator, put/call ratios for index options are a different story. I’ve discussed a couple of times recently the put/call ratio for OEX (S&P 100) index options, and how they have been an effective non-contrary indicator. So when I saw today’s OEX put/call ratio of 1.88, I was somewhat disturbed, as that is quite high historically. Even given the fact that it is option expiration week, I still think outsized moves should be investigated.
Digging a little deeper into today’s reading for OEX options, one fact quickly stood out – open interest in the puts actually declined by 4,000 contracts, while call open interest rose by 10,000 contracts (open interest simply tells us how many contracts are currently open – it doesn’t tell us whether the contracts were bought or sold to open, only that a new contract was created). As you can see from the open interest put/call ratio on the site, high levels of put open interest have typically been found near market peaks, while low levels have most often been found near market lows.
The reason I think today’s decline in put open interest is notable is because it is extremely rare. Since 1997 (1,850 trading days), put open interest has declined from the day before on only 74 days (4% of the time). This is excluding the day after expiration, when it will decline by definition. This is the second time in the past week that put open interest has declined. Over the past 7 years, any time put open interest has declined twice within 5 days, the S&P 500 was higher 70% of the time after 30 days, with an average return of 3.0%. After 90 days, the S&P was higher 75% of the time, and the average return climbed to 7.7%.
Related to this is something that I have shown before, which I call the OEX Determination Index. This index is constructed by taking the amount of call volume that goes into an increase in call open interest, compared to put volume going into an increase in put open interest. The higher the index, the more put volume is going into new positions (and/or less call volume going into new positions). Therefore, when the index is low, it means either that there is little put volume going into new positions, and/or there is a lot of call volume going into new positions – theoretically, this should be bullish for the market since it shows that OEX traders are quite determined to have a bullish posture.
As we can see from the chart, the Determination Index has a fairly decent record at being high near market peaks and low near market troughs – further strengthening the belief that OEX traders should be viewed as a non-contrary gauge. Currently, the index is the lowest since March 2003, but is still not yet what I would consider extremely positive. It is approaching extreme territory, but as is clear from the chart, it has gotten quite a bit more stretched at prior major lows.
Conclusion
Nothing really has changed in the past two days from what I said in the last comment - I continue to believe that it makes sense from a risk/reward perspective to initiate or add equity exposure on weakness, with the intention of holding for several months. We went long with about 25% of the model portfolio on yesterday’s gap open, and will likely add to that if we see further weakness and our measures continue to support an intermediate-term rally.
In the short-term, our indicators still are not giving much of a guide. There are usually one or two good moves during expiration weeks before things settle down on Thursday and especially on Friday, but with almost all of our short-term measures still stuck in neutral, I see no sense in pushing either direction at the moment.
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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