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THURSDAY a.m.
August 28, 2003



Puts and Calls
by David Nichols

One of the most bullish data points floating around right now has been the high put/call ratio. Conventional wisdom holds this to be bullish for the market overall, as a preponderance of put volume -- meaning a surplus of bets that the markets will go down -- represents a potentially valuable contrarian indicator.

But the reality of put/call ratios is far more complex than this simple rule-of-thumb. In fact, I don't find put/call ratios to be all that useful, for the main reason that it's impossible to ascertain from raw options data the actual intention of an options trader. If you're buying a put, you're bearish; but if you're selling a put, that's a highly bullish strategy. When a put changes hands, we don't know if that trader is buying or selling, which makes a big difference if you're trying to determine the sentiment mixture.

Many sentiment-watchers like to look at the equity-only put/call ratio, because this is where the "wrong-way" options players are more likely to be hanging out. Index options are often used by institutions to hedge large portfolios, so it's harder to glean a meaningful sentiment clue from these index options markets. In other words, some of the time, index options players are right, and other times they are wrong. It's not so helpful as a leading indicator.

Lately the equity-only put/call ratios have been high. Yesterday's reading came in at 1.08, meaning there were more puts traded than calls -- seemingly a bullish data point. But as Jason Goepfert (a contributing Analyst to 21st Century Alert through his site sentimenTrader.com) points out, if you back out QQQ options from this reading, then the picture is not-so-bullish.

Here is Jason's explanation, which is so illuminating that I just want to run it verbatim here:

"Once again today, the CBOE put/call ratio closed at a very high level. Earlier this week, I discussed the unusually high put/call ratio seen on Monday and what implications it may have on the broader market. While the headline put/call number gets all the attention, I can't help but continue to point out the distorting effects of QQQ options. The headline put/call ratio today was 1.08, but if we back out QQQ options, then it falls down to 0.83, which is about average in terms of recent history. Over the past three days, the headline ratio has averaged 1.06, but the ratio without QQQ options is only 0.89.

Why back out QQQ options? I've gone over this topic many times, so suffice it to say that it is largely an institutional vehicle and I don't believe it is representative of a contrarian indicator. I've shown the QQQ put/call ratio several times in the past, and it is clear that there is no pattern to it as either a contrarian or non-contrarian indicator. Sometimes high QQQ put/call ratios lead to rallies in the QQQ, sometimes they lead to declines. As I've said before, I find this ratio no better than random, so if we can back out this "noise" from the general put/call ratios, I think that's valuable."

QQQ put volume now regularly exceeds 30% of total equity put volume. About one year ago, the 100-day average stood around 10%. Now it is over 20%. Any single sector that regularly accounts for 30% or more of volume should certainly be accounted for. The chart below shows the equity put/call ratio with QQQ options subtracted out, on a 10-day moving average basis, with six-month Bollinger Bands framing it.



we accept the above chart as being a more accurate reflection of those most often wrong on market direction (I certainly do), then the put/call ratios are far from being bullish, and are in fact only now beginning to recover from one of the most bearish (for the market) readings in its two-year history.

On Monday, I outlined the past instances of extremely high put/call ratios, and the evidence was quite bullish for the market. However, I think when QQQ options are factored in -- and they MUST be -- then the bullishness wears off considerably. While we could certainly see a little pop in the market after the numbers we've seen over the past few days, it would take many more days of the non-QQQ ratio being elevated to get me to believe that the traders most wrong on market direction are becoming too fond of put options."

Yesterday was one of the smallest ranges in the market in a long, long time, with the S&P 500 moving within a 5 point range all day long. That's the very definition of market "noise", and it was a truly forgettable trading session.

It's certainly possible for this listlessness to continue through next week, as many market participants are on vacation. But you can't count on that. I keep thinking back to last year's July 5th half-day session, which was a "sneak attack" to the upside on very thin volume, off some random economic data point.

During that half-day, holiday-thinned session last year, the SPX raced from 954 to 989. By the way, the VIX closed that day at 31.89, as opposed to yesterday's reading of 20.34. People are far more bullish now at these same price levels than they were a year ago, which is one of the craftier ways a bear market perpetuates itself -- by continually lulling people into more and more bullishness at lower price levels.

Sentiment Dashboard
by Adam Oliensis



SENTIMENT TANK: Filled 3 points to 13% full of negative sentiment.

SHORT-TERM: Continued in its weak advance phase.

MID-TERM: Raw score dropped a point, putting the gauge at 81/19. Still neutral, now with a bearish bias on the oscillator. However Confidence is at a bullish 1. Trying to achieve homeostasis at a bullish height. Will give either a continuation buy or sell reversal signal on either surprising economic news as the week draws to a close, or else early next week.

LONG-TERM: Progressed a point to 10% on the decline side, but with Confidence regressing to a neutral 0.