Historic Put/Call Action Seen This Week

08/10/2011 6:00 am EST


Moby Waller

Editor, Wyatt Research

The put/call ratio surpassed the 1.00 level this week (and did so on record volume), an event that has historical significance, but does not readily predict how long, or how severe, the current correction will be.

After last week’s crazy market action, Monday’s trading set some more option volume records. It shows the continuing growth and use of options (especially on the VIX and ETFs) among both small and large investors and traders.

According to the CBOE, for the second consecutive day, trading volume reached an all-time high on Monday. Over ten million contracts traded hands once again, the fourth time in history this has occurred and the biggest single-day volume ever—topping the "flash crash" of May 6, 2010. 

VIX options volume, VIX futures volume, and total ETF options volume have also set records in recent days.

However, even with this giant volume, the equity-only put/call ratio on the CBOE didn’t surpass the 1.00 threshold on either Thursday or Friday. The readings for those days were 0.96 and 0.93, respectively.  

A reading below 1.00 indicates that fewer puts than calls were traded, even on those huge market-down days. The equity-only put/call ratio does include ETFs such as the Spyder Trust (SPY) (and inverse/ultra ETFs), but doesn’t include indices like the S&P 500 (SPX).

Finally, on Monday, this measure of option trading sentiment surpassed 1.0, coming in at a 1.08 level. This came as stocks shed another huge amount of value and SPX closed in on the key round-number 1100 level.

Prior to Monday, the most recent times when this ratio surpassed 1.0 were in June 2011 (June 10, 15, 16, and 17, precisely). Before that, this hadn’t happened since 2009. 

In the past five years, the occurrences were:

  • January 7, 2009
  • September 15, 2008
  • October 9-10, 2008
  • November 6, 2008
  • November 19-21, 2008
  • March 6, 2008
  • March 14, 2008
  • March 17, 2008
  • January 15, 2008
  • August 14-16, 2007

Prior to that, there were no occurrences since August 2004.

I broke down these incidents of very high equity put/call ratio readings to analyze if they showed trends in terms of trader panic and market timing. Several of the data points were "stand-alone" while others occurred in small bunches in the same month—the latter were grouped together. 

This basically made for eight previous instances, and on the following chart, we will list the SPX performance in the one, five, ten, and 20 trading days afterward.

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Basically, this is a fairly rare event over the past five years, as you can see. For the "bunched" events, we used the final day the put/call ratio was over 1.00 as the measuring point for SPX performance. The average market performance following all of these events was very neutral over the five-, ten-, and 20-trading-day time frames (corresponding to one week, two weeks, and one month).

There was a noticeable trend in this admittedly small sample size (see blue box at top of graph). When the CBOE ratio had a "stand-alone" reading over 1.00 which was not followed by any more high readings in the near term, it was a bearish indication for stocks. The SPX was down 3.0%, 6.0%, and 7.9% in the five-, ten-, and 20-day time frames following this.  

One can assume the logic behind this was that the market was complacent following a big down day or very bad news (or some huge put buying), and the longs got hurt by further downside.

The other sample group is when there were multiple readings over 1.00 in the same month, usually within a one-week or two-week time frame. Following the final reading over 1.00, the SPX was up 3.2%, 5.4%, and 5.0%, on average. 

Here the logical conclusion is that after a period of extended bearishness (equity put/call ratio over 1.00), the market crossed up the bears with a strong rally. This could be viewed as typical contrarian analysis/behavior, but also could indicate the sellers/bears were worn out after so much negativity.

So now we come back to Monday’s reading over 1.00. At this time, we don’t know if this is a single-time occurrence or if there will be several more in the coming days/weeks. 

Considering we didn’t breach 1.00 last Thursday or Friday, it’s possible that this may be a one-off, but the sense of panic and huge drops we’ve seen would also point to heavy continued put buying.

How is this going to play out? Well, targets I had focused on for support with the SPX have been breached (the Fibonacci 1228 and round-number 1200 levels). We closed right around another long-term 50% Fibonacci level of 1121, just above the 1100 round strike, which certainly could act as support. 

With another big down opening likely ahead of us, below those levels lies another big potential support of 1014 and the psychologically important 1000 level. And then there’s the shudder-to-think 666 low of March 2009.

Keep an eye on these measures of sentiment, like the VIX and put/call ratios, to see if/when the downside punishment will continue or if a market bounce is imminent, and if any rally attempt will stick. Likely, when we do "bottom out," we’ll have rallies combined with a volatile consolidation trading range.

By Moby Waller of BigTrends.com

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