Options Market Not All That Encouraging

12/29/08 9:10 AM EST

Good Monday morning...we begin the day with a muted reaction in the pre-market futures, and most other markets.  We're once again seeing buying demand in "safe-haven" Treasuries, but we'll have to wait a bit for some traders to return from vacation to get a better read on things.

One of the pointedly negative indicators showing up on our lists over the past several sessions has been put/call ratios.  While a major options expiration and extremely light volume are impacting the indicators, they're not enough of a reason to discount what the ratios are saying altogether.

Almost all of the averages (5-day, 10-day and 21-day) that we watch for the Total Put/Call Ratio and the Equity-only Put/Call Ratio are above their bearish (for the market) trading bands.  Below is the chart of the Total Put/Call Ratio that we post to the site.

This is a relatively rare event during a bear market environment.  We've seen it twice since last October, those dates being October 5th of last year and May 14th of this year.  Both were excellent "sell" signals.

Overall, there were 29 days when all three averages of the Total Put/Call Ratio were above their red trading bands, while the 200-day average of the S&P 500 was sloping down.  The returns in the S&P going forward were sub-par, showing positive returns across all time frames up to three months later less than 30% of the time.

A month later, for example, the index was positive only 4 out of the 29 days, with an average return of -4.3%.  The average maximum loss during the month-long trades (-6.3%) was more than twice as great as the average maximum gain (+2.7%).

Those four days that showed a positive return over the following month were in March 2003.  The market dipped briefly afterward, then resumed its upward march out of the bear market.  When the market was not in bear market environment, then the go-forward returns after signals like this were actually positive - a month later the S&P was up 62% of the time.  So it was not a good sell signal during healthier markets.

Because these ratios only use general options data, they can at times be misleading.  That's why I like to also consult the ROBO Put/Call Ratio of small-trader activity.  There, we know *who* is doing *what* with their options trades.

Last week, these small traders reduced their speculative call buying activity to less than 25% of their total option volume.  That's a very low amount that shows a great deal of risk-aversion.  So much so, in fact, that it has been a pretty good buy signal.

The bad part is that at the same time, they also greatly reduced their purchases of protective put options to only 16% of total volume.  That, too, is an exceptionally low amount that was last seen as the market was topping out last December.

So if they weren't buying calls or buying puts, what were they doing?  They were selling calls (39% of total volume) and selling puts (20% of volume).

Interestingly, we've seen this exact same behavior only twice before - at the end of December 2001 and the end of December 2002.  I think it's relatively safe to say that this is part of a year-end strategy on their part.  For what it's worth, after these traders behaved in this manner in 2001 and 2002, the S&P rose over the next one to two weeks both times, then fell apart.

Our short-term signposts were pretty positive last week, pointing to about a 70% chance of a rising market.  But that has changed, with all of them now pointing lower over the coming sessions, giving about a 40% chance of a rally.  Given the very low volume and extremely choppy trading, I'm not a fan of trying to sell short in here, but I would be more willing to do so if the S&P can't hold above that 850ish area that should act as some form of support.

From a more intermediate-term standpoint, we have gone over a number of different positive indications over the past few weeks, but the buyers haven't been active enough to push us higher.  We've pretty much done nothing since the Thanksgiving week rally.

That activity has pushed a number of our longer-term indicators back into overbought territory.  While *extreme* overbought conditions have actually been bullish when coming out of extreme oversold conditions (see here and here and here), we should be seeing more of an impetus to buy.  Maybe we just need to wait until traders close the books on 2008, but it's disturbing that we haven't seen more buying interest.

A move back under 850 on the S&P would have me back-pedaling on the "longer-term rally" idea, and a break of 820 will see me all but abandon it.  What we need to see is a sustained move over 920 to confirm the higher high / higher low pattern that is still valid.

All the best,