A Mixing Bowl of Readings

Bottom Line: Put volume in SPX options has been extremely high lately, and historically that often preceded positive markets. However, it is probably not as bullish as it seems at first blush, due to the increased number of contracts in circulation.

Something that was pointed out today by Brian Reynolds, Chief Market Strategist of M.S. Howells & Company, is the exceedingly high put option volume (relative to call option volume) in SPX options. “SPX” is the ticker symbol for options traded on the S&P 500 index, and it is a popular battleground for institutional investors. While I track SPX option activity daily, and indeed post a derivative indicator to the site, I have always been leery of reading too much into these options because they tend to be dominated by institutions, and due to their structure are often sold to open. I’ve discussed many times how selling options to open completely changes the meaning of option activity, and indeed a moving average of the SPX put/call ratio has not provided much insight in the past.

However, there has been interesting market action after extremely high SPX put/call ratios in the past. While some, maybe even most, of this activity is undoubtedly expiration related, on both Friday and Monday the SPX p/c ratio closed above 4.0, meaning there were four times as many put contracts traded as call contracts. This is extraordinarily high, and had been matched only 12 other times since 1997. The following table outlines each of the other times this ratio reached 4.0 or higher, along with the performance in the S&P 500 the given number of days later. The columns highlighted in yellow are those times, other than the most recent occurrence, that the put/call ratio was above 4.0 within a few days of each other.

SPX Put/Call Ratio Above 4.0 1997 - 2004
DATE	SPX P/C RATIO	5 Days Later	10 Days Later	30 Days Later	60 Days Later	90 Days Later	120 Days Later	250 Days Later
06/11/97	4.22	2.3%	2.2%	8.4%	6.3%	6.7%	10.3%	25.4%
10/22/97	4.49	-5.3%	-3.3%	0.7%	0.2%	7.9%	15.3%	14.4%
10/30/97	4.01	3.5%	1.6%	5.4%	8.3%	18.0%	25.6%	24.5%
05/18/98	5.25	-0.7%	-1.2%	3.6%	-0.3%	-5.7%	3.5%	25.7%
02/12/99	4.10	3.1%	0.3%	7.0%	11.0%	10.1%	11.8%	22.1%
07/26/99	5.15	-1.5%	-3.1%	2.7%	-4.7%	8.0%	9.5%	14.9%
12/02/99	4.66	0.6%	2.6%	6.0%	-1.8%	8.5%	5.3%	-7.3%
08/31/01	4.44	-3.3%	-14.8%	-4.1%	0.2%	-0.4%	2.5%	-21.0%
05/22/03	4.47	2.9%	5.6%	7.7%	7.1%	6.2%	10.1%	13.8%
12/22/03	5.94	1.3%	3.1%	3.2%	0.3%	0.7%
05/21/04	4.93	2.0%	4.0%
05/28/04	4.38	1.9%	1.4%
06/18/04	4.88
06/21/04	4.11
Average Return		0.6%	-0.1%	4.1%	2.6%	6.0%	10.4%	12.5%
% Positive		67%	67%	90%	70%	80%	100%	78%

We can see from the table that the market was higher a majority of the time five days later. Out 30 days, the S&P was positive every time but once, with an average return of 4.1%. At six months out, the S&P was positive every time, sporting a hefty average return of 10.4%.

Other than near the low last month, the ratio had only recorded readings above 4.0 within a few days of each other one other time, in October 1997. After the second occurrence, the S&P went on to substantial gains over the next year. While it would be a stretch of the imagination to associate one day of high put volume in SPX options as a cause of fabulous market gains a year later, I think it pays to look at those longer time frames.

In the six years from 1997 through 2002, there were eight of these put/call readings above 4.0. In just the last year, however, there have been six of them, and I suspect we will continue to see more of these types of extremes. The reason is because put open interest (the number of option contracts in existence) is at its highest levels – by far – of any time since 1997. While call open interest has also risen over the years, it has not undergone the constant growth that put open interest has, especially over the last year.

In the chart above left, we can see that call open interest has basically remained flat over the past year (the spikes down in the chart correspond to option expirations). The above right chart, showing put open interest, shows a very clear uptrend. Open interest has climbed steadily higher before expirations, and remained higher after expirations. As put open interest increases, we should expect put volume to increase too, simply because there are more put contracts open that are often closed out or rolled over to a new month as expirations approach.

As far as what this all means, my opinion is that the recent extreme SPX put/call readings are more of an affect from the huge open interest that has been built up in the put options more than anything else. There are so many institutions that use these options for so many different strategies, that it is difficult (if not impossible) to draw any conclusions about what high or low put/call readings may mean. The table above appears to support the idea that very high p/c readings are bullish, but to me it is a minor point at best.

Bottom Line: Newsletter writers are excessively optimistic according to what they are saying, and historically that has lead to sub-par market returns.

One trouble spot is the willingness for traders to switch to bullish stances as soon as we see a rally. Our AIM Model of investor and analyst opinions is now back under 40%, historically a warning signal that bullish opinion has become excessive. I am fully aware of how poor a guide this was in 2003, but if you subscribe to the theory that we will most likely see a trading range type of environment over the coming months (as I do), then excessive bullishness should be more troublesome for the market than it was last year.

Part of the AIM Model, the Investor’s Intelligence survey, is once again showing a bull ratio of more than 75%. The bull ratio shows the total percentage of respondents that are bullish out of those that express a definite opinion. The table below shows how the S&P has performed since 1969 after various levels of the bull ratio.

S&P Performance After Various Stages of Bullish Opinion 1969 - 2004
	Six Months Later		One Year Later
	Average Return	% of Time Positive	Average Return	% of Time Positive
Excessive Bears*	6.2%	73%	16.0%	83%
Normal	4.3%	68%	8.3%	73%
Excessive Bulls	2.9%	63%	4.2%	56%
Today’s Level	1.6%	58%	1.9%	48%

* Excessive Bears = bull ratio less than 45%; Normal = bull ratio between 46% and 71%; Excessive Bulls = bull ratio greater than 71%; Today’s Level = 76%

From the table, we can determine that since 1969, anytime the bull ratio showed that we were seeing excessive bearishness, the S&P returned an average of 16% one year later, with 83% of the occurrences being positive. That compares to a non-extreme average of an 8% return and 73% positive instances. After periods of excessive bullishness, the S&P returned only 4% with 56% of the times being positive. When there was an amount of bullishness that matched our current level of 76%, the S&P showed an average appreciation of only 1.9% one year later, with fewer than half of the instances being positive.

As we saw last year, this type of data can mean nothing, and can in fact hurt our returns. However, over time the percentages should continue to play out, and it is a reason to expect below-par returns going forward, as long as this type of excessive bullish opinion persists.

For the past two weeks, our short-term measures have been mired in neutral territory, which I suppose is a good thing considering the market performance. Other than intraday traders, it has been hard for others to gain much of an edge in either direction. While I have been suggesting that strategies using oscillating indicators would work better than those attempting breakout strategies, I didn’t think it would apply only to those using 30-minute time frames. The S&P 500 has been stuck within a 20-point range for the past 11 days, and while the usual argument is that low volatility precedes high volatility, historically instances of extremely tight ranges such as we’ve seen over the past two weeks have lead to tighter-than-usual ranges over the next two weeks as well. With volume so low, and sentiment extremes so hard to come by, I wouldn’t necessarily trust any “breakout” that occurs in the short-term. The current environment is difficult for those with time frames of 3-5 days, but the first overbought or oversold confluence we get from our short-term measures should set up a nice opportunity.

Longer-term, I see no reason to alter what I have been saying in each of the last few comments, as it continues to be my view…May saw an important intermediate-term low, declines that put us into an oversold situation should be viewed as opportunities to add or initiate long exposure, we should see modest gains for the year, but the best strategy will most likely take advantage of oscillating indicators (selling overbought conditions and buying oversold ones) rather than breakout strategies. The closer we are to the top of the trading range, the less inclined I am to be holding long 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.