Point of Recognition
Sunday, August 8th, 2004 10:45am EST
Some Put/Call Precedents
Bottom Line: Friday’s put/call ratio was the highest in a decade. Looking at other examples of extraordinarily high ratios, we see a clear pattern emerge, as the high put volume coincided with a point of recognition that more declines were likely ahead.
Friday’s break of support finally brought out some of the signs of give-up among traders that we have been waiting for so long to see. One of the most egregious examples can be found in the put/call ratios, which spiked to extremely high levels.
As you know, I prefer to look at the options volume figures from the Chicago Board Options Exchange (CBOE) with QQQ options removed. QQQ has become an institutional playground, and those options are not reflective of individual investor behavior. By taking them out, we can normally get a better read on investor sentiment. However, since the data only goes back a few years, and total put/call data goes back further than that, I want to discuss the total ratio, which includes all option volume on that exchange.
On Friday, the total p/c ratio spiked to 1.38, a modern-day record – we would have to go back about 10 years, when the accuracy of this data is somewhat sketchy, to find a higher reading. Looking at the top 10 readings over the past decade, a certain pattern emerges – extremely high put/call ratios rarely coincided with major intermediate-term lows. Many times, such as in June 2002, September 2002 and February 2003, the extreme spike in put volume seemed to occur with the moment of recognition that something was wrong. However, within an average of about three weeks, the market found a major low. Within 32 days of every one of the top 10 put/call ratios, the S&P found a price level that allowed it to rally a minimum of 5% within 30 days. The average rally from that low point after 30 days was a very hefty 12%. After six months, the S&P was an average of 20% higher.
Let’s take a look at three recent prior lows that are remarkably similar to what has occurred recently. First, we’ll go back to late June 2002, when the S&P enjoyed a major reversal on June 14th by rallying more than 25 points off its intraday low. The market showed strong follow-through the next day, leading many to believe that we had finally put an end to the long Spring decline. However, when the market fell back and reversed the reversal a few days later, the put/call ratio shot higher – the point of recognition that the decline was not yet over. 21 days later, the market put in an intermediate-term low.
In September 2002, a similar event occurred. After a devastating decline on September 3rd, the market was able to work higher for the next week and a half after testing that low two days later. On September 18th, it became painfully clear that the early September low was only temporary, and once again the put/call ratio spiked to an exceedingly high level. The short-term support level was broken, once again registering as a point of recognition among traders that the ultimate low was net yet at hand. 16 days later, the final low was put in.
The most recent occurrence was at the low in Spring 2003. After the stiff decline in early January, the market flip-flopped for 7 consecutive days in late January and early February, giving traders hope that the selling pressure had dissipated. However, on February 6th that short-term trading range was busted to the downside, and the put/call ratio spiked up to 1.35. That again served as the point of recognition that short-term support was not the intermediate-term low. It took another 22 days before the final low was created.
When compared to our current situation, the circumstances look remarkably similar. We put in a short-term low several days ago, increasing the belief that perhaps the worst declines of the year were behind us. After the test of that short-term low failed, the put/call ratio spiked to a level exceeding the previous instances by a hair, suggesting that Friday was perhaps the point of recognition for traders that there is more selling to come.
I point out these precedents because the similarities are intriguing. Obviously, with three examples there is nothing statistically significant about any of this. And, each of the others occurred in the context of a bear market, whereas our current is coming off a year that showed spectacular gains.
In the previous three instances, the S&P declined an average of 13% over the course of about 20 days from the date of the extreme put/call ratio to when the index finally bottomed. Of course, the market does not have to follow this template. Friday could have been the low, like October 8th, 1998 – the date of another extremely high put/call ratio. Or even like a couple of months ago, May 10th, when the March lows were broken and the put/call ratio spiked to 1.28. That also served as a pretty good entry point for long positions. If we do not see an immediate reversal, with the 1075ish level of the S&P regained within the week, it seems as though the three examples given above are a better guide to what may happen than are the latter ones.
Conclusion
The idea that Friday served as a point of recognition among traders is reinforced by a few other measures that we follow. Volume in the SPY and QQQ exchange-traded funds was extremely high on Friday, showing that traders were rushing into some of the most liquid (and easily shorted) vehicles possible. This moved our SPY Liquidity Premium close to levels seen at past lows, though it is still not quite what I would consider truly extreme. Also, Rydex traders moved $74 million out of the leveraged bull funds and an amazing $114 million into the leveraged bear funds, an extreme about-face from the type of activity we had been seeing recently. This $188 million shift is the second-largest in four years, behind only September 3rd, 2002. As you can see from the chart on the site, the leveraged bear funds are perhaps one more bad day away from setting an all-time record in assets under management (use the Chart Quick Pick feature and scroll down to Total Leveraged Bull & Bear Assets under the Rydex section).
We need to see more of this type of give-up among traders. Given how the market has performed, it is discouraging to see the Market Vane sentiment survey still showing bullish opinion well more than 2 standard deviations above its long-term mean. It is extremely worrisome that our R.O.B.O. put/call ratio of small options buyers actually declined this week, and remains very low. Those kinds of things need to change.
In several comments in late July, I noted that “range-think” was pervasive, meaning that the idea of an extended trading range had caught on and traders were not becoming more bearish as prices fell, assuming it would just rebound back up to the top of the range. This was unlike what we saw in March and May, and it made me think the range would need to be broken in order to get the types of readings which usually lead to a better low. Towards the end of July, we saw several signs that suggested at least a short-term low was at hand, and while we did get a short-term rally, it fizzled out more quickly and more severely than I thought was likely. I think we will be higher than we are now by the end of the year and we should see one more excellent rally beginning in the next few weeks, but I do not think the decline is yet over. The put/call precedents as above should serve as fairly adequate templates for what we may see going forward – the point of recognition has now been triggered, and it may take a couple of weeks to see the type of give-up among more traders that accompanies longer-term lows.
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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