Still More Confirmation

Bottom Line: Despite recent protestations to the contrary, the recent historic put/call ratio readings are bullish, as a breakdown of the underlying strategies confirms.

I’ve touched on various aspects of the put/call sentiment statistics several times over the past few weeks, and they have gotten so much press lately that for many of you, your eyes glaze over at their very mention anymore. Like with anything that gets a lot of attention, there has been an increasing number of skeptics coming out of the woodwork concerning these numbers, and today we will see if there is any merit to these arguments. If you are one of those who is sick of hearing about anything to do with puts or calls, just know this – a detailed analysis of the underlying strategies tells us that the recent activity has NOT been an anomaly due to some strange strategies. Put options have simply been the vehicle of choice among all tiers of options traders, and that is bullish for the market.

Such interesting readings, especially with a rallying market, have inspired all sorts of theories. The most common one (espoused by bears, no surprise) is that the high put/call ratios are actually a bearish development because it doesn’t fit with how the put/call ratio acted in the past. Usually, we saw a week or two of extremely high put/call ratios only after a severe downtrend. The fact that the CBOE total put/call ratio continues to record readings above 1.0 even when the market rallies must mean that something else is going on – the typical argument being that institutions are selling the options to open, which is one reason the volatility indices have remained muted. That seems like a reasonable argument, but it doesn’t stand up when we look at the actual data.

The numbers we get daily from the CBOE do not break down the volume figures any further than just the totals for puts and calls. On a weekly basis, however, we can get much more detailed information from the Options Clearing Corporation, which clears the option volume from each of the major options exchanges. This organization gives us the data we need to see to know just what has caused the increase in the put/call ratios. This is also where we get the data for our R.O.B.O. put/call ratio^TM that is posted to the site.

First, let’s get some context by looking at the total put/call ratio from the OCC. This includes all volume from all exchanges, excluding that of market makers and the like. Theoretically, if the data is of any use to us here, it should track the data from the CBOE fairly closely. In fact, it does – a two-week average of the OCC total put/call ratio has had a nearly perfect correlation of 0.95 to the 10-day total put/call ratio from the CBOE over the past four and a half years. Here is a chart of the OCC ratio:

Now that we know that the data from the OCC has tracked the data from the CBOE extremely closely since 2000, it should give us some confidence to dig further into the OCC numbers and apply the insights as to why the put/call ratios from the CBOE have been so high, and have been getting so much attention.

The typical interpretation of the put/call ratio is that traders buy puts because they expect prices to fall, and buy calls because they expect prices to rise. The more put volume we see, the more we assume traders are expecting falling prices. And because whenever a lot of traders have the same idea, it usually doesn’t happen, excessive put volume is considered a contrary indicator and is bullish for the market. Conversely, a lot of call volume means traders are betting on rising prices, and the market instead usually falls afterwards.

That is the typical interpretation, but it is grossly simplistic. Option volume is not made up just of traders buying these contracts as discussed in the paragraph above. They can also sell options to open, in which case they would have about the opposite opinion as the typical interpretation. And with the daily data from the CBOE, there is no way for us to know if that is what they are doing. In fact, theoretically much of the CBOE volume figures could be traders selling options to open, and in that case a high put/call ratio would be interpreted in the exact opposite manner! That is what some of the bears are suggesting is happening, and which we will now disprove.

The volume figures can be made up by four different things happening. Either the options are being bought to open, bought to close, sold to open or sold to close. Each of those actions has a different interpretation, for both puts and calls. The table below outlines this.

If they implement this STRATEGY,	Then with CALLS, they are being…	And with PUTS, they are being…
Buy to Open	Bullish	Bearish
Buy to Close	Bullish	Bearish
Sell to Open	Bearish	Bullish
Sell to Close	Bearish	Bullish

First, let’s look at what traders have been doing with call contracts. The following chart shows the total number of call contracts traded for all customers on all options exchanges so far in 2004, broken down by each of the four possible strategies:

With both puts and calls, it is clear that the strategies follow each other closely. When traders are buying a lot of calls to open, they tend to also sell a lot of calls. In January of this year, call volume reached near-record proportions, but it was not simply traders buying a lot of calls. Likewise, in mid-May traders were showing significant pessimism by buying an increasing number of puts to open. But they also increased each of the other strategies involving puts. From these charts, and an analysis of past behavior, it becomes very clear that while a majority of the volume, for both puts and calls, is comprised of buying the options to open, overall increases in volume are usually not due to that alone. When the market rallies, traders tend to concentrate on call strategies and when it falls they tend to concentrate on puts. When that concentration reaches an extreme, no matter the strategy involved, it tends to coincide with a market turning point.

In mid-May, we can see why the put/call ratios were so high. Call volume (all strategies) was relatively low, certainly much lower than it was in January. At the same time, put volume (again, all strategies) was quite high and had risen considerably from early April. It is absolutely false that the high put/call ratios have been caused by traders selling options to open. They have been caused by a combination of call strategies losing their luster and put strategies becoming the focus. The greatest contributor to total put volume was traders buying the contracts to open, which is in keeping with the traditional interpretation, and is a reason why the extremely high nature of the ratios was (and continues to be) a positive development.

Bottom Line: There does not appear to be any particular bias on the days surrounding exchange closings for Presidential funerals.

There were some suggestions today that the rally could have been partly due to some display of sympathy in honor of the passing of former President Reagan (the NYSE will be closed on Friday in honor of his funeral). I believe that’s a huge stretch of reality to say the least, but it prompted me to look at previous NYSE closings in honor of fallen Presidents.

Market Performance Surrounding NYSE Closings in Remembrance
President / Date	Day Before Market Closed	Day After Market Closed
McKinley 09/19/01	+0.5%**	+0.3%**
Roosevelt 01/7/19*	+0.0%	+0.2%
Harding 08/10/23	+0.0%	+0.5%
Wilson 02/06/24*	+0.2%	-0.3%
Taft 03/11/30*	-0.2%	-1.5%
Coolidge 01/07/33	+1.1%	-1.0%
Roosevelt 04/14/45	+0.8%	+1.7%
Kennedy 11/25/63	-2.8%	+4.0%
Hoover 10/23/64*	+0.2%	-0.2%
Eisenhower 03/31/69	+0.4%	-0.1%
Truman 12/28/72	+0.5%	+1.0%
Johnson 01/25/73	-1.3%	-0.2%
Nixon 04/27/94	-0.2%	-0.6%

Avg Return	+0.0%	+0.3%
% Positive	62%	46%

As sad an event as these may be, they carry little economic impact and do not have enough of a history for traders to profit from self-fulfilling seasonal tendencies such as is seen around market holidays, so as expected there is no distinct pattern that emerges from the other closings. Personally, I find this all a bit distasteful and quite frankly am content that there is no identifiable edge around these ceremonies.

As you can see from the site (click here, then choose “June”), the month of June has historically shown quite a positive bias in the first five days of the month. However, the sixth and seventh trading days (Tuesday and Wednesday this week) have been very negative, consistently showing returns well below a random day. After that, the month has historically rebounded to give more random-like returns before once again exhibiting weakness towards the end of the month. There is some other seasonality fighting that weakness, which is the Presidential election cycle. I outlined the typical course back in February, and so far the market has followed that script very well. As I said then, the market had a tendency to chop for the first five months of the year before often gaining some traction in June and running into the end of the year.

Longer-term, I continue to believe that the market is acting extremely well, and day after day reinforces the research from May that suggested an intermediate-term low was imminent. While it would have been preferable to see a pullback off the short-term overbought readings last week in order to add more long exposure, I still see no reason to bet against this rally except for very short-term scalp-type trades.

In the short-term, as I said last time I would not fight any short-term trend that was kicked off by the jobs report. Since the report took on added significance in February, the broader market has been able to sustain minor trends in the first few days after each report. This is no surprise after a day like today, but we’re once again seeing some overbought readings from our shortest-term measures, though it is not yet to a degree that suggests shorting is a high-odds endeavor. I believe it’s prudent to lighten up on the long side, but I don’t think the time is right to bet aggressively on the short side.

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.