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MONDAY, JULY 28, 2008

Selling Pressure Not Leaving Much Of An Edge

07/28/08 3:20 PM EST

As of: SPX 1251 HELP  ARCHIVE

On Friday, we had a narrow-range day , and we went over a couple of different ways to look at it, which resulted in either a bullish or bearish bias depending on how you wanted to spin in.

I don't like murky studies like that; I prefer clear-cut edges.  I checked the pattern again, this time looking for any instances since 1982 (when reliable intraday reporting began) when we had a 1% loss on the S&P 500, then a narrow-range day, then another 1% or greater loss.

There were eight occurrences in that span, the latest one being this past May 23rd.  That one had a typical outcome - buying at the close of the second 1% loss and holding for three days resulted in seven winners out of the eight, with an average return of a respectable +1.3% and a 2-to-1 reward-to-risk ratio.  The one loser in July 2000 led to some short-term selling, then the S&P went on a seven-day upstreak that erased the losses.

Forgetting the narrow-range day, since the October 2007 high it's been surprisingly effective to buy into these kinds of declines.  When the S&P lost at least 1% on two of the last three sessions, then buying and holding at the close of the second 1% loss for three days resulted in 11 winners out of 13 attempts, with an overall average of +1.1%.  The average drawdown (i.e. maximum loss) during the next few sessions was just a bit smaller than the average maximum gain, though, as moves were quite volatile.

That's perhaps a minor positive - it doesn't blow me away as far as edges go.  We could also point a finger at seasonality, which is turning a bit positive as we enter the end of the month.  The last three days of July have been positive about 70% of the time over the past 30 years (closer to 60% prior to that), which has held fairly steady over the past three decades.  If the month was positive heading into the end of the month, then the end-of-month results were more positive (67%) than if it was negative (57%), which is what we're dealing with here.

The beginning of August has not shown the same kind of positive seasonal influence that most other months have, so the "positive seasonality" window is pretty short-term.  I don't weight seasonality very heavily anyway, so I wouldn't consider this any more than a very slight potential positive bias in the days ahead.

These are fairly weak studies and I'm not relying on them as a basis for doing any trading.  I thought as the S&P 500 touched 1240 that we'd be seeing more of an upside edge, but I'm struggling trying to find much of anything on either the long or the short side.

Our most sensitive indicators are heading back towards their oversold zones, but most of them have a ways to go before they hit a true extreme.  And I'm also troubled that the last round of oversold readings from Thursday didn't translate into anything more than a limp, narrow-range, one-day relief bounce before the indices rolled over again. 

For now, I'm not adding any short- or intermediate-term positions.  The indices are starting to hit some widely-watched retracement levels, which can prove to be good setups if they coincide with other studies, or sentiment- and breadth-based oversold indicators, but I'm finding a lack of a solid bias in those categories.

Small Traders Collecting Some Premium

07/28/08 9:20 AM EST

As of: SPX 1251 HELP  ARCHIVE

Good Monday morning...We begin the day with flat action in the pre-market futures, a modest rebound in commodities led by Oil, , mixed-to-weak foreign equities markets and a light weekend news flow.  The economic calendar is heavily weighted towards the end of the week with the GDP and jobs reports, so the near-term will likely be dominated by the continued earnings parade.

One of my favorite pieces of weekly data is the release of options trading data for the smallest of options traders (those trading 10 contracts or less), which comprise the ROBO Put/Call Ratio.  The data covers trading activity for the prior week, and while it isn't often extreme enough to provide an actionable signal, it is a fascinating look at the mindset of individual mom-and-pop operators.

For the latest week, there wasn't much change in their buying of speculative call options, which held steady at near 33% of their total volume.  Their purchases of protective put options, though, fell from 25% of total volume the prior week to 20% last week.  25% was a decent sign of excessive uncertainty, and 20% is about in the middle of their range over the past few years.  It would have to drop under 17% or so before I would consider it to be a sign of too much complacency and a lack of desire to protect themselves against the possibility of a market drop.

The most interesting part of the report was the fact that selling call options to open took up 32% of their opening volume, the biggest chunk in years.  For those not familiar with options, an individual investor usually "sells a call to open" when they own the underlying stock, and don't expect it to go much of anywhere to the upside (or downside).  This lets them collect a little bit of income on a stock that otherwise wouldn't be doing much for them.

Because of the way the strategy works, the customer loses if the stock makes a big move up (in which case their stock gets "called" away and they don't get to participate in the rally) or a big move down (in which case the small amount of option premium they got up front doesn't help a whole lot).

This call-selling strategy is often promoted as a way for investors to boost their returns in a dull market.  It's most often marketed by brokers and personal finance magazines after the stock market has already dropped, and we see that reflected in the behavior of these small traders.  For example, the heaviest call-selling we've seen in the past 8 years was in March 2001, September/October 2001 and the spring of 2003.  Those were all times stocks dropped dramatically, investors sold call options to salvage a little bit of their fallen stocks - and then they got the shaft when stocks rallied.  The true winners during those times were the market makers (or other customers) would bought the call options.

It's because of this tendency that I like to keep an eye on all the various strategies that small investors employ to see if they're doing something which might backfire.  The recent surge in call selling is telling from a psychological point of view, but it's not to a level that's screaming out an extreme.  In 2001 and 2003, call selling made up an extraordinary 45% or more of small-trader total volume, so we have a ways to go.  If it jumps to 40% or more in the coming weeks, then that will be something we'll discuss more in depth.

All the best,

Jason Goepfert

President and CEO

Sundial Capital Research, Inc.

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