Skepticism is High on Further Gains
Tuesday, October 5th, 2004 8:30pm EST
One Last Note on Options Traders
Bottom Line: Not to beat a dead horse, but another look at a different population of options traders suggests skepticism about a further rally is very high, which from a contrary point of view is a point in bulls’ favor.
I really don’t want to keep harping on put/call ratios, as it is only one aspect of trader sentiment and I think I covered it pretty extensively in the last comment. However, there is one other measure of option trader behavior that I have tracked since its beginning and it, too, is giving readings that strongly suggest traders are ill-positioned for a rally (which should be a bullish sign).
The International Securities Exchange (ISE), a relatively new player as far as options exchanges go, quickly found its footing and now often challenges the old-school Chicago Board Options Exchange in terms of trading volumes. Last month, for example, 34% of all equity option volume traded on the ISE, compared to 26% on the CBOE. This makes the ISE a force to be reckoned with, and since they often account for more volume than the CBOE, their data may be just as useful.
Most people who analyze put/call ratios use the data supplied by the CBOE, but beginning in October 2002 the ISE also began publishing something it calls the ISE Sentiment IndexTM (ISEE). This Index does the CBOE data one better by only including customer orders (to the exclusion of market makers and the like), and is constructed using opening purchases only. This is similar to our very own R.O.B.O. put/call ratioTM, but for the R.O.B.O. ratio we additionally restrict our look to trades for 10 contracts or less (isolating our analysis to the smallest of options traders – those most likely to lose their bets).
Over the past week, the ISEE has averaged 135, which means that customers have purchased 35% more calls than puts. This is actually a pretty low reading, as the mean seen since the inception of the data is 155. The chart below shows the entirety of the data.
From the chart, we can see that the Index approached 200 in late 2002, telling us that traders were buying to open twice as many calls as puts, certainly a sign that we could be seeing excessive optimism. That sentiment was quickly reversed, and the Index bounced between 100 and 150 while the market was bottoming in the Spring of 2003.
Several times throughout 2003, the ISEE spiked above 200 temporarily, and for the most part that type of seemingly speculative activity made it difficult for the broader market to post and hold gains going forward. In a week of orgy-like call buying, the ISEE was above 200 for five straight days in mid-January of this year, which should have tipped anyone who was looking to the possibility that pessimism was hard to find. However, something interesting has happened since then – each successive peak in the market has been accompanied by less and less call buying. Perhaps this is an indication that traders are learning from the trading range. After all, if the S&P has declined every time it has flirted with the 1150ish level this year, why buy calls now when it will probably just fail again?
The data from options traders that I have discussed in the past couple of comments is a compelling argument that the skepticism surrounding the ability of prices to rally has become so strong among so many that that is precisely what we most likely will do. I believe it is folly to try to be contrarian just for the sake of being contrarian, but when we have data such as we have seen over the past few days, it is hard evidence that traders are not believing in this rally. If they don’t believe, then chances are high that they have cash on the sidelines or are short shares, which could fuel a price rise, particularly if we see clear technical breakouts which tend to get so many traders excited.
Conclusion
It’s never a terribly good idea to rely on one piece of evidence when forming an investment opinion, and in my mind all put/call data is one piece of evidence. No matter where the data comes from, it essentially monitors the same type of information. I do find the points I have discussed the past couple of days to be compelling enough to suggest that prices should not break down appreciably from here, and may in fact lead to a continuation of the rally.
In the last comment I suggested that it probably wasn’t a good idea to chase any strength early in the week, as we should fall back into Friday’s range at some point during the week. We’re not quite there, but I think if we see a little additional weakness, that may be about it before another rally attempt is made. What may throw a wrench into that possibility is that we’re close to entering the weakest part of the month. Over the past 53 years, only 4 of the 15 trading days from the 5th through the 19th trading day of the month have been positive a majority of the time. A few of them have been positive less than 40% of the time, which, considering the positive slope of the market since 1950, is quite a feat. To see this phenomenon for yourself, go to the Seasonality section of the site, then click on “CHARTS” next to “Performance by Day of Month”, and click on October in the window that pops up.
My strategy going forward will be to cover any existing short positions on further weakness, as I anticipate there is a pretty strong bid underneath the market which should prevent us from moving materially lower. I would much prefer to see some at least short-term oversold readings before adding long positions, and if we happen to see that this week, it should be a low-risk time for longs.
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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