Trader’s Narrative

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.

Today (until midnight), courtesy of Dow Chemical (DOW), you can take a peek inside the subscription only side of The Street (RealMoney.com).

I would especially recommend the following writers:

Helene Meisler
Tony Crescenzi
James Altucher
Doug Kass

If you’ve read this blog for some time you know that I’m a great fan of popping the hood on price and looking at what is really driving the market (Market Internals). One great indicator is the advance decline number which shows you, on any given day, how many stocks closed up and how many closed down.

Since this indicator can have wild swings from one extreme to the other the daily chart looks too “noisy” to be of any value. We can take out the noise by using a moving average or we can calculate a running total by adding each successive day to the previous and make it a cumulative indicator.

Here’s a typical way that this indicator is used (see graph on left). It comes from Michael Panzner who writes in the AOL money&finance blog.

He concludes from the graph that “since mid-April, this popular measure of market breadth has been something of a laggard, despite the fact that the technology-laden index has been trading near multi-year highs.” While not calling for a crash, he says that this means that the bulls will have to “tread carefully” because the “market lacks the broad participation necessary for a sustainable advance”.

Sounds reasonable, right? Let me show you why its incorrect.

First of all, we have to step back and take more data into consideration.

The graph below shows the Nasdaq cumulative advance decline numbers from around September 2005 to today. The red box contains the graph that Panzner shows above:

Things sure look different now, don’t they?

Negative divergences are all over the place. But the market actually goes up. In fact, if you keep going back historically you find that this is the norm. The long term Nasdaq cumulative breadth index looks like a ski hill with a few moguls here and there pausing the decline momentarily.

Very strange. Logic would seem to dictate that a stock market needs advancing stocks to power ahead. So why is it that we see a disconnect between a persistently falling cumulative breadth with lower lows and lower highs, and the market?

Believe it or not, there is a very good reason. But it is not apparent to everyone. It sure wasn’t apparent to me either. A few years ago when I noticed this strange and persistence divergence I contacted one of the best technical analysts that I knew: Helene Meisler. She was kind enough to school me.

From that point on I never bothered looking at a cumultive breadth graph again (until now) and instead used the moving average of advancers and decliners.

I’m surprised that Michael Panzner, who is as his blurb claims, is a 25 year veteran of the markets, doesn’t know. Or perhaps he does and purposefully cuts off his graph (red box above) at just the right spot to buttress his claim.

Hmm… do you think it might have anything to do with the fact that Michael Panzner is the author of “Financial Armageddon: Protecting Your Future from Four Impending Catastrophes“?

Such bombastic predictions may sell books but they won’t do much for your portfolio.