Waiting for the Entry

Bottom Line: I normally run for the hills when seeing the type of hyperbole in that headline (as it usually comes right before the “first” failure), but a signal given by a decline in the OEX open interest ratio has had a 100% success rate on the long side over the past 10 years.

I frequently discuss the goings on in OEX options, with the assumption being that these traders are “smart money”, or at least good market timers. That assumption is not built on blind faith, but rather years of hard evidence that shows these traders being seemingly well-positioned at most major market turning points. We post several indicators to the site which tracks this group of traders, one of which is the OEX Open Interest Ratio.

The Open Interest Ratio very simply compares the number of open put contracts in that index to the number of open call contracts. If the ratio is high, then these traders have opened (and not closed) a large number of puts relative to calls – this is something we often see near market tops. On the other hand, a low open interest ratio often coincides with market lows.

Due to expirations and other events, the actual ratio can be pretty “jumpy”, so I like to view it in other ways, such as using a rate of change. Rate of change just looks at the current reading compared to one a given number of days ago. For example, if the reading today is 1.5, and six months ago it was 1.0, then the six-month rate of change would be 50% (meaning the current reading is 50% higher than the one six months ago). I bring this up because currently this rate of change reading is giving what has historically been an extraordinarily bullish signal.

Six months ago, the open interest ratio was 1.85, a high reading that often comes near market peaks (it just so happened to do so this time around as well). Over the past month, put open interest has risen significantly less than call open interest. In fact, for the first time since 03/17/03, OEX traders have more call contracts outstanding than put contracts. So over the past six months, the open interest ratio has declined by 47%, one of the largest negative six-month rates of change in 10 years. The table below shows how the S&P performed after other similarly large declines.

S&P 500 Performance After Large Declines in OEX Open Interest 1995 - 2004
	10 Days Later	30 Days Later	60 Days Later	90 Days Later	120 Days Later	250 Days Later
Avg Ret	3.0%	7.5%	12.4%	16.7%	20.4%	30.1%
% Pos	79%	98%	87%	100%	96%	96%

There were a total of 53 days over the past 10 years that showed such extremely large six-month declines in the OEX Open Interest Ratio. We can see from the table that such events were historically extremely bullish for the market, as the S&P 500 was higher after 30 days every time but once, with an average return of 7.5% (resulting in an average annualized gain of around 63%). This was not just a bull-market phenomenon, either, as over a quarter of the signals occurred during 2000 – 2002.

Something other that is notable is that put open interest actually declined on Friday and Monday. As I noted on May 17^th, the last time we saw a similar thing, a multi-day decline in OEX put open interest has had a tendency to have bullish undertones for the market. Contrast that to times when call open interest has declined from one day to the next – we saw that in January, April and June of this year, all of which coincided with market weakness going forward.

While the open interest configuration in OEX options can get much more extreme (e.g. there were nearly two calls open for every put at the panic lows in September 2001 and July 2002), the current value is already more than one standard deviation below the long-term mean value – meaning these traders currently have an unusually large number of open call positions relative to open put positions. Given the record of these traders, and this specific indicator as we saw in the table above, it adds another mark to the bullish side of the ledger.

Bottom Line: The TRIN indicator on both the NYSE and Nasdaq reached short-term overbought levels that have only come out of severely oversold markets this year.

In Sunday’s comment, I noted that if we were to get an early-week rally this week, it would become paramount to see how the market reacted off any short-term overbought readings that were generated. In the indicators that are updated intraday, we track several measures to gauge these overbought/oversold levels, such as the TICK, TRIN, put/call ratios and the VIX. It is the TRIN values we saw today that I would like to discuss further.

I have noted many times my beefs with the TRIN (or Trading Index, or Arm’s Index, or whatever you prefer to call it). Recall that the indicator is calculated by following formula:

Whenever you take a ratio of a ratio, one small deviation in one of the numbers can cause a wide swing in the overall number. In addition, as we saw last year several times with Lucent, huge volume in a low-priced stock can cause a very large distortion in the TRIN. Despite these weaknesses, however, one has to admit that the indicator has done a pretty good job this year and it continues to defy its critics as a consistently useful tool.

Late yesterday and early this morning, the TRIN values for both the NYSE and the Nasdaq were extremely low. This tells us that there was likely very heavy volume in a few issues that were higher on the day. While that doesn’t necessarily mean anything in and of itself, when we are coming off of very oversold readings like we are, it tends to portend good things.

In the intraday charts, we show data that is taken every ½ hour during the trading day, and that is what I would like to show here. The chart below shows the S&P 500 versus a simple addition of the NYSE and Nasdaq TRIN (on an inverse scale). For example, as of 2:00 pm EST yesterday afternoon, the TRIN on the NYSE was at 0.34 and on the Nasdaq it was at 0.26. Both of those are extremely low, and when we combine them (coming up with a total of 0.60), we can note that it was the most “overbought” those indicators had been, on an intraday basis, all year except for one other time.

At 1:30pm EST on March 25^th, the NYSE figure read 0.41 while the Nasdaq figure was at 0.18, giving us a total of 0.59. On May 19^th, the NYSE was at 0.33 while the Nasdaq was at 0.37, giving a total of 0.70. Those are the only other times so far this year that the combined figure totaled 0.70 or below. What’s notable is that those other two instances were the first thrusts off the lows formed a few days earlier. After a day or so of rest after these extreme overbought intraday TRIN readings, the markets took off on healthy rallies.

This type of data is exactly what I was looking for when I said that I wanted to see how the market reacted off any overbought readings we would happen to see early in the week. We have now seen the overbought readings, and so far the market has reacted well.

In an intraday comment this morning, I noted the complete shift of sentiment we have seen in the Rydex assets. On the heels of yesterday’s impressive point gains, traders in those funds shifted a minimal amount of money into the bull funds and out of the bear funds – a lack of long-side commitment not seen since early 2003. That these traders are now so suspect of a rising market should be considered a longer-term positive, as it adds potential fuel to an upside surprise if and when they realize the downtrend may be over. As always, it isn’t the absolute amount of money that these traders control that is important, but rather the probability that they reflect the sentiment of a larger pool of traders/investors.

Many of the signs are here that we have reached a sentiment extreme, meaning substantially and sustainably lower prices are unlikely. We also got a sign that we have seen an initial buying thrust off the low, something only seen at the lows in March and May. The ideal scenario from this point would be to see another leg lower, even making new lows, to shake out those who tried to pinpoint the exact low. Such an occurrence should present the best long-side opportunity all year, but unfortunately it seems as though many others are thinking the same thing. I don’t like to be contrarian just for the sake of being a contrarian, but it makes me uncomfortable when an event seems to be so anticipated. I also detest trying to buy into a rising market. If we take off to the upside from here, we will likely be left with our modest long exposure until things settle down. If we do get another leg lower, however, we will almost certainly be adding to our long position.

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.