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.

I use Interactive Brokers as my primary broker because of their price and offering but also because they consistently improve and add new features. They put the Japanese companies to shame when it comes to kaizen.

Usually they follow the requests made by their clients - I’ve been with them long enough to remember a time they grudgingly gave in to demands for trailing stop losses because Thomas Peterffy believed they weren’t good for the health of markets (I am not kidding!!). But they also innovate and surprise their fans with new features.

They recently announced a raft of new features, products and markets. If you are a serious trader and looking for a broker, check them out.

Here are the recent additions:

New Products & Markets

• US Treasury Bonds and Notes
• Vanguard No-load Mutual Funds
• Mexican stocks, futures, and options
• Spanish stocks

The first two are huge news because as far as I can remember, we’ve been pestering IB for it. The even better news is that fixed income will be expanded soon to include T-Bills and that other mutual fund families will be added as well. IB was at one time proud that they stuck to just derivatives and equity markets. Finally, they are branching out to other financial products.

The expansion to Mexico and Spain are also welcomed. Especially since I have familiarity and interest in the Spanish equity market. IB has offered Spanish derivatives for some time but now the lineup is complete.

IB Block Desk
The biggest news is this! Interactive Brokers is opening up their institution block desk to retail customers. Now if your orders are big enough (100+ contracts), you can call them up and get a tighter spread or more liquidity than electronic markets. The desk also offers you access to the Spoos (the S&P 500 open outcry market or pit), OEX, NDX (and their options).

Answering calls will be experienced, knowledgeable traders who can tackle anything you throw at them, including complex derivative trades. But this is a very surprising development since Interactive Brokers has adamantly refused to do anything but push deeper into electronic markets through sophisticated trade matching computer algorithms.

IB Risk Navigator
This is a relatively new built in quantitative tool that will monitor and manage your risk exposure across countries, markets, currencies and securities. Think of it as your very own risk manager. IB has added a few extra capabilities to it but unless you trade a gamut of securities spanning markets or dabble in options heavily, then you probably don’t need it. In case you’re interested, IB is offering two Webinars to explain it in more detail: March 26th and April 23rd.

Trader Work Station
The TWS is the trading platform from IB and most people fall into two camps: they either love its simplicity or hate its clunky look (and Java-ness). In any case, IB isn’t going to chuck it any time soon so if you’re thinking of opening an account with IB this may be the only deal breaker. You can always use their web based interface but it has very limited functionality compared to the TWS. IB has finally tried to mollify its critics by adding skinning, so you can customize the look of the TWS.

I can’t help but think that a lot of these uncharacteristic new features and markets are a result of Interactive Brokers becoming a public entity last year.

If you’re shopping for a broker, click to see last year’s best broker ratings from Barron’s.

Looking at the percentage of stocks above their 50 day moving average is a quick and dirty way to find out where the market stands in the medium to short term. Looking at the percentage above 200 day moving average provides a much broader perspective.

Line In The Sand
The 200 day moving average is like the proverbial “line in the sand”. If a stock can’t hold above it, technically speaking, things are really rotten. But while that may be negative for one individual stock, when as a whole the market crosses that threshold, it usually is a sign that things have reached an extreme and are about to return to normal.

Right now, the percentage of stocks above their long term moving average are at levels which in the past have seen a resumption of the bull market. The index that got the most oversold was the Nasdaq Composite (COMPQ) which reached 34%. The next one was the S&P 500 (SPX) which got as low as 43%.

Large Cap vs. Small Cap
But there is an obvious dichotomy. Whereas the broad indices (containing a mix of small caps and large caps) show an extreme low reading for this indicator, the large caps are almost unscathed. The Nasdaq 100 (NDX) index, for example, has 60% of stocks above their 200 day moving average while the S&P 100 (OEX) has 62%.

This is no surprise since we all know that the small caps have gotten crushed in this correction. A cursory look at the Russell 2000 (RUT) shows it correcting about 12% (from recent high to recent low) - almost double that of the large caps.

Unless for some reason you believe that we are heading into a new bear market, this is as bad as it is going to get. I reiterate that this is a buying opportunity if you have a medium to longish time horizon. Especially the financial sector.

Here’s the chart for the NYSE and the S&P 500. Notice the difference between a bear market bottom and bull market inflection points:

The S&P 100 options are views as a smart money indicator and right now their ratio of open calls to open puts is less than one. Which means that the smart money holds more calls than puts. This is worthy of note because it is quite rare.

Since 1995, it has proved to be a high probability play, returning a monthly average of almost 4%. I think a sustained upside breakout here would take almost everybody by surprise since we’ve already had quite a sustained move up recently.

But isn’t that the market’s modus operandi?

Source: sentimenTrader.com