Trader’s Narrative

The first time we looked at the Credit Suisse Fear Barometer, it didn’t look like it had anything useful to offer. But using it in combination with its competitor, the VIX index, it may yield surprising insight into options sentiment and the stock market.

The VIX has declined from its stratospheric highs to reach close to its long term average of 20. That may suggest that there is little fear in the market. But that isn’t really accurate because right now traders are willing to pay more for put options than for (equivalent) call options. We can tell that because the CSFB is higher.

The last time we had a CS Fear Barometer rising while the CBOE volatility index was falling was in early May 2008 (shown above) - just before the S&P 500 rolled over into another waterfall decline.

Source: Battle Of The Fear Indexes

That is just one instance but the others also provide the same general idea. The S&P 500 has a very tough time on average, going up when the VIX has fallen and the CSFB has gone up.

So it seems the ugly duckling of an indicator has suddenly become a swan. When paired with the VIX, the CSFB seems to unfold even more meaning for the stock market.

Check out my original review of SentimenTrader.com to see why I highly recommend Jason’s insights. As you can see from the above analysis, he’s well worth your money.

Kick back and catch up with what you may have missed at this weekend’s reading list. Here are just a few examples from news.tradersnarrative.com:

• The Bond War
• If You Want to Make Money Trading, Stop Thinking About Making Money Trading!
• The Financial Markets and Fear Itself
• Investors sceptical on stock market rebound
• Get a FREE Subscription to Financial Magazines
• A Rally Led by ‘Junk Stocks’
• The Ability to Not Trade: An Unappreciated Contributor to Successful Trading
• Bearish Divergence in the VIX and the S&P 500?
• From Ordering Steak and Lobster to Serving It
• The New Socialism
• The S&P 500 Conundrum
• Presidential cycle: Bullish for rest of this year

For the complete list, follow the graphic below:

And remember to check back regularly since there are interesting links added throughout the week.

Week Ahead: Inflation Worries Return

This weekend’s Barron’s introduced a new measure of “fear” in the stock market developed by a team from Credit Suisse’s equity-derivatives trading and strategy desk. It is called the Credit Suisse Fear Barometer (CSFB). A clumsy name for what seems to be a clumsy indicator.

To break it down, they are looking at zero cost collars and measuring the skew between the upside target and the downside protection. So for example, in October 2008 when the S&P 500 was plummeting and the CBOE volatility index was screaming higher (reaching a high of 89%) the Credit Suisse Fear Barometer was around 10%.

This implies that, back then, if you were long the index you could have put on a costless collar at +/-10%. Put into context, this means that there was almost zero fear in the market. Huh? Does that make sense to anyone? All you had to do was have a pulse and watch the market to know it was one of the most turbulent chapters in market sentiment.

The dynamic duo at Credit Suisse have backtested their indicator all the way to 1998 and shown that it has a small range (at least compared to the VIX). The minimum was 10% (as mentioned above) in October 2008 and the maximum was March 2007 when it reached 30%. But March 2007 was a market top (of sorts) in the S&P 500. Again, it makes no sense to say that this was a “fearful” time in the market.

These are just two data points from the series and to analyze it further you need a Bloomberg terminal. But here is a sneak peak courtesy of Jason Goepfert:

Source: Is The New CSFB Fear Index A Bust?

Now I’ll be the first to admit that the VIX is not an ideal sentiment indicator but does the CSFB make any sense as an indicator? Do you see any relationship between either the VIX or the S&P 500 and the CSFB?

Useless sentiment indicators abound out there and they keep being calculated and disseminated like zombies. Looks to me like the CSFB is a prime candidate for the round filing cabinet - even before it arrived! - which is some kind of record. But maybe I’m being too hasty, we’ll give it a few months to see what it says in real time, based on historical performance the bar is set low indeed.

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When the market started to take a dive, the vast majority of the usual technical indicators started to blink green, one by one. The one that didn’t and has arguably continued to refuse to cooperate with a bullish scenario is the options market. And more specifically, the difference flavors of put call ratios. First I’ll go over the data and then try to provide some explanations. If you have a better one, by all means, drop me a comment.

Week after week, as the markets plummet headfirst into an abyss, the options market confounds everyone by reflecting no fear, not even rational caution. For example, on September 19th the waterfall decline we’ve experienced so far was still to unfold but the CBOE equity only put call ratio went to 0.62 - the lowest it has been in a month.

From then on things just went from weird to strange to downright confusing. On the same day as the CBOE put call ratio was putting in that strange performance, the ISEE Sentiment Index which is a different measure of the options market, fell to 66 - showing significant fear (although not extreme according to its history). Then just a few days ago, on October 20th the ISEE Sentiment index actually rose to 146 - meaning that retail traders were shunning puts and flocking to calls!

To be fair, for two consecutive days (September 9th and 10th) the put call ratio spiked higher than 1.0 But when you consider both the speed and depth of the market’s fall (more than 40% from the 2007 October highs) it is astonishing that we have not seen a mad dash to buy puts as we have in every single bear market decline in recent history, pushing the put call ratio much higher and sustaining it above 1.0 for a full week or more.

So what is going on?

The most obvious explanation is that because of the astronomical volatility, options are extremely expensive. So Joe Sixpack or Joe the Plumber thinks twice about buying put protection for his portfolio. Or just doesn’t and hangs on for dear life. Here are some other explanations:

Michael Kahn
One explanation, offered in Barron’s Getting Technical column is that the government ban on short selling of financial stocks (quickly amended to include others as well) not only threw out the normal balance of the options market, but also skewed the VIX index, propelling it to unheard of levels. But wouldn’t the ban on short selling have meant that people would be creating synthetic short positions (selling calls and buying puts)? or just buying puts?

Helene Meisler
Helene Meisler is the technical analyst savant at thestreet.com where she has been, unfortunately, put behind a subscription wall. I’m not sure if she has already written about this in her The Street columns but according to her what we are seeing in the options market is par for the course for a true bear market. She explains that in a bear market, people are forced to liquidate everything, even their winners. So there’s nothing for them to protect via puts. They then may buy puts outright believing the market’s going lower.

Jason Goepfert
Jason Goepfert of SentimenTrader explains that it is not unusual to see a mismatch between the put call ratio and a true bottom. Historically the market has bottomed out a wee bit after the options market indicated massive fear.

At the same time, he also notes the effect of the short sale ban saying that some brokers had not been allowing their clients from exercising put options unless they already had the shares in a long position.

Apart from the ISEE sentiment index and the CBOE put call ratios, Jason provides his own measure of the options market: the ROBO ratio. Right now it is in agreement with the other options metrics, indicating no real concern on the part of small retail options traders. Amazingly enough, they were much more scared during the market decline in March 2008.

Silver Lining
I don’t want to make a mountain out of a molehill but even after considering the whole short sale ban, the options market has been behaving in a very uncharacteristic way. The only silver lining I can see around this confounding cloud is the way the OEX option market has been going. It is preferred by the “smart money” so it is not interpreted as a contrarian indicator.

Monday’s free falling market finally brought us some indication of real fear in the market. The indicator that got many talking was the S&P 500 Index volatility index (VIX) being pushed higher than what we saw at the last financial crisis in 1998 (when a few PhD’s from Chicago almost took down the world economy with a little hedge fund called LTCM).

I wanted to take a closer look to see that spike in its proper context. So here is a long term chart of the VIX:
Continue reading ‘The Heartbeat Of The Stock Market Goes Thump’