I Found the Little Guy - And He's Buying Call Options!

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July 22, 2007

8:30 PM EST

I Found the Little Guy - And He's Buying Call Options!

This weekend, respected financial publication Barrons ran a cover story titled "Where's the Little Guy?". The crux of the article was that small investors hadn't fully embraced the bull market, as determined by a multitude of real-money and anecdotal evidence.

This is a theme I've been harping on for months, as many of our indicators have not reacted the way we would normally expect them to given the break to new highs in the major indices. Heck, all we need to do is look at a few of the small-trader indicators we post to the site.

Check out Odd Lot Short Sales. On Friday, these bets against the market for under 100 shares apiece topped 8 million shares total for only the second time in history. The first time was on the day of the mini-crash of February 27th of this year.

Or how about Small Speculators in the major equity index futures. Those guys are currently holding about $13 billion worth of S&P 500, Nasdaq 100 and DJIA futures, one of the lowest amounts in the past seven years.

We could also look at how much money is flowing into the bullish funds at Rydex and Profunds. While these traders have been reducing their bearish bets, they certainly have not been piling into the long-side funds betting on more of a general stock-market rebound.

Penny stocks are a favorite of small traders in boom times because they increase the chances that a small account can hit the big-time by buying one of these lottery tickets that rides the trend higher. But Over-The-Counter volume has not exploded like it did during the bubble years, and in fact has been very subdued lately.

So there is some solid evidence backing up Barrons' contention that the little guy hasn't joined the party.

As always, though, those willing to do a little digging can find conflicting data, and I'm sure we can find an article or two from those hoping for a market decline that shows the little guy not only bullish, but fully invested!

So it's our job to separate the bulls from the bullshi* and figure out just what it is we should be doing.

Options - the Best Way to Lose the Most Money in the Least Amount of Time

The indicators I mentioned above are all solid. Each of them carries some baggage (reasons why we should doubt the data), but overall I'm still comfortable with the signals each is giving and they are all pointing to gains for stocks as more and more traders convert to the long side.

I do want to play devil's advocate just for a second here, though, as we got a piece of data this weekend that really stood out.

We've seen a string of very low put/call ratios over the past couple of weeks. Like all indicators, there are reasons why we should doubt the readings - like games being played from "income" option mutual funds, and even the just-passed expiration.

There is one set of options data, though, that seems quite pure. The ROBO Put/Call Ratio that we post to the site only looks at trades for 10 contracts or less, so it's highly, highly unlikely that we're seeing any trades from big mutual or hedge funds...this is strictly mom-and-pop kind of stuff.

Not only that, but we also only look at options that are bought to open. There's usually only one reason why a small trader is buying a call option, and that's to speculate on the upside; there's also only one reason they buy a put, and that's to bet on a fall.

So when we see extremes between call buying and put buying from very small traders, we can get a pretty good read on how these traders are thinking. Unfortunately, they tend to get their most aggressive just as the market is about to turn the other direction, so this is considered a contrary indicator - when these traders are bullish, then we should doubt the potential for future stock-market gains.

Last week, these guys and gals bought 2.7 million call options, which is a new all-time record. But hey, maybe they also bought a record number of put options, too, which wouldn't tell us much.

So let's look at the data in relative terms. Those 2.7 million call contracts ended up equating to 47% of all of the volume for these traders. In other words, of all the options trades for 10 contracts or less last week, just under half of them went to buy call options.

That sounds like a lot, and it is:

We can see from the chart that we've seen similarly high call buying (as a percent of the total) only a few times since the peak of the bubble, the last time being right before the summer swoon last year. Once again, these traders had loaded up on the long side at just the wrong time.

Here's another way to look at it, which is the total percentage of volume they spent buying speculative call options minus the percentage of volume they spent on protective puts.

We can see that the indicator has formed a very defined range over the past several years, so let's just zoom in on that range and get more detail.

The indicator has been pretty good at highlighting market extremes. When these small traders got too optimistic, then the return in the S&P 500 two weeks later averaged only -0.2% with 38% of them showing a positive return.

But when these traders got too pessimistic - when put buying surged relative to call buying - then the two-week return in the S&P was +1.7% with 10 out of 11 weeks showing a positive return. As you can tell by the little green arrows on the chart, the returns just kept getting better and better after that.

When we see readings like the current one, it has tended to be more successful as a "caution" signal than an outright "sell" signal. Like most sentiment indicators, when the market is in a strong uptrend, and then we see excessive optimism build up in our indicators, it's best to lay back on initiating new long positions or perhaps hedge a bit with some put options, but it's usually not the best idea to kick out all of your long positions willy-nilly.

Conclusion: Short-term May Be a Little Dicey, Longer-term Still Looks OK

I haven't posted a longer-term comment for almost two months, and there's a very good reason for that: we've been seeing a huge number of either neutral or conflicting readings among the guides that we follow. If one of them does manage to climb to an extreme, then we usually have another one that's giving an opposite signal.

When we see that in the context of a strong trend, I tend to just step back, shorten my time frame, and go with the flow. If these indicators aren't giving us a strong edge, then it's best to not read too much into them. Our shorter-term ones have given us some good signals over the past couple of months, but the more intermediate-term measures have mostly oscillated between bullish (for the market) and neutral.

Like I noted above, there are some solid indicators pointing to the idea that the little guy has not yet embraced this bull market, and in the big picture I would agree with that idea. But every once in a while we'll see a pocket of speculative excess, and typically the market will back off or at least stop going up in a sustainable manner afterwards, at least for a couple of weeks.

The options data we looked at above suggests that's what we're getting now, but longer-term the other indicators outweigh this one and I would suspect that although the shorter-term may get a little dicey, there's little evidence that we're seeing the kind of outright bullishness that has preceded most other major sustained declines or (gasp!) bear markets.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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