Watching This Week Closely

Bottom Line: Our guide to small-trader option buying activity has finally shown a spike higher. This display of pessimism is one of the missing pieces we have been mentioning. While not yet truly extreme, it is a welcome change.

In the last few comments, I have been saying that more and more pieces are falling into place, meaning that each week (and nearly each day), we are seeing more signs of excessive speculation on the part of traders that are normally on the wrong side of the market at turning points. Assets in the leveraged bear funds at the Rydex mutual fund family are hitting new all-time records, odd lot short sales are spiking, some of the sentiment surveys are showing a very low number of bullish respondents, and Chicago Board Options Exchange’s total put/call ratio has closed above 1.0 for four out of the past six days. It is a relative of last measure that I would like to discuss today.

I’ve gone over this in more detail before, but very briefly put/call ratios measure the amount of volume traded in put options versus that of call options. Put options are generally used to protect against falling market prices, while call options are used to speculate on rising prices. So when put volume is high relative to call volume, it has traditionally been thought of as a sign of excessive fear from traders, who are scrambling to protect themselves from a market decline.

While it is a nice, clean concept in theory, when looked at in a more detailed light some major weaknesses in data such as that from the CBOE are evident. Most importantly, we don’t know who is trading the options (it could be a very smart, large hedge fund doing most of the trading), and we don’t know what they are doing. If a large, successful fund is selling a ton of put options, it would show up as a spike higher in the put/call ratio, even though it is a bullish bet by a smart trader. That’s not what we want to see in a contrary indicator.

As an attempt to solve those issues, we update the R.O.B.O put/call ratio on the site each week. This ratio is calculated by using only those trades for 10 contracts or less, and only those trades that are being bought to open. With an average transaction size of $200 - $2000 or so, we know we’re dealing with the very smallest of options traders. By restricting our search to only those options that are being bought to open, we know exactly what these small traders are doing. By virtue of their size, it’s a pretty safe bet to assume that they are not involved in complex options strategies – when they buy a call to open, they are speculating on rising equities prices; when they buy a put to open, they are protecting themselves or more likely trying to speculate on a down move. Therefore, when our ROBO ratio spikes higher, we know that we are seeing fear from those traders most likely to be wrong on market direction.

In the past few comments, I have mentioned that this ratio has been stubbornly low. Despite the fact that other put/call ratios had been rising recently, this ratio was not, and it certainly was not at a level that would suggest there was any panic among these traders. Finally, this week, that has changed – for the first time since May 2003, these traders purchased nearly 75 puts for every 100 calls they bought. This is still shy of the extremes seen at the other intermediate-term lows over the past few years (when purchased puts matched or exceeded purchased calls), but it is a major shift from the extremely low figures we had been seeing since the beginning of the year.

The shift in attitude to one of trying to speculate on declining prices instead of trying to catch the next bottom can perhaps be most clearly seen in the following chart, which shows what percentage of total volume these traders used for purchasing put contracts.

Last week, these traders concentrated just over 22% of their total volume on purchasing puts as opening transactions – a clear bet on declining prices. This is the largest bearish concentration, by far, since the week ended March 14, 2003. It is definitely a far cry from January, when only 10% of their volume went to such activities.

While this heightened level of bearish bets coincided pretty much with the exact lows in the springs of 2001 and 2003, it marked the beginning of the acceleration of the severe declines in June/July and September/October 2002. When put purchases from these smallest of options traders reached this level in June 2002, the S&P declined another 15% over the course of 6 weeks before the final low was reached. In September of that same year, the S&P dropped an additional 10% over 5 weeks. The table below outlines each occurrence.

Date	Put Purchase %	S&P 1 Week Later	S&P 6 Weeks Later
04/12/01	23%	5.0%	8.0%
06/14/02	24%	-1.8%	-15.3%
08/30/02	23%	-4.0%	-8.8%
02/14/03	23%	1.6%	3.4%
03/14/03	23%	7.5%	7.9%

While this is by no means even close to a statistically significant sample, an interesting side-note is that the two times that the S&P was lower one week later, it was entering the waterfall stage of the decline. The three times it was higher the next week coincided with pretty good lows. This would suggest the upcoming week is an important tell – if we cannot rally in the face of such pessimism by these wrong-way traders, then we may be headed for trouble. Again, with only a handful of samples, any conclusions are tenuous, but I think it’s important enough to note.

I’ve gone over quite few moderate positives over the past week, and we continue to add to them as the days wear on. So far, the break of obvious support and its “point of recognition” is following other instances closely. The choppy conditions from the past week should be resolved this week, one way or the other. The overall bias of our work suggests that resolution should be down and we break last week’s lows, but there are certainly enough positives that should we regain the 1075 level I had talked about previously (and more importantly 1080), the probabilities rise dramatically that the worst is behind us.

In the short-term, our measures are completely mixed after last week’s mush. There are really no true extremes to speak of, and it is difficult to decipher much of an edge from our perspective when we see this kind of neutrality. The deep oversold conditions we saw to start off the week have been worn off with a choppy market, but should we get some short-term overbought readings with an early-week rally, and if price continues to rally in the face of those, then we will have an excellent first sign that we are undergoing a bigger trend change.

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.