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Option Traders Reach For Gains, Forget Risk Completely at Trader’s Narrative





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Yesterday, both of the option indexes that I monitor hit a spike high in complacency and greed. The CBOE put call ratio (equity only) fell to 0.43 while the lesser known, ISE Sentiment index (equity only) call put ratio hit 253.

While they both measure option trading activity, there are some differences between them. For starters, the CBOE put call ratio includes large trades while the ISE Sentiment index tracks more retail option traders. Also, the CBOE is a put call ratio while the ISE is a call put ratio. So to be able to compare them better, let’s convert the CBOE put call ratio to the format of the ISE Sentiment index: 294.

So basically, for every 100 put options traded, there was between 253 and 294 call options traded. That’s a lot of greed. Granted, it was just one day. But spikes of such intense emotion deserve our attention. Not only was the spike enough to help the short term moving averages shift dramatically, there is evidence that similar daily spikes presage short term weakness in the market.

I decided to look at all the history of the ISE Sentiment index (equity only) call put ratio and see what has happened in the S&P 500 after a spike of 250 or more, like we saw yesterday. Here are the results:

ISE sentiment index equity only spikes compared to S&P500 index Mar 2010

Including yesterday’s there have been 24 instances (the ISE data goes back to January 2006). Most of them tend to cluster around early 2006, mid-2007 and the fall of 2007. In the short term, the average return for the following 21 trading days (1 month) was -1.08%. Out of the 23 occurrences, 14 were negative and 9 positive.

For all 4 time intervals the returns were negative. But keep in mind that this was a period with a very deep bear market. As well, notice that when we move to the longer end, the 12 month return is negative on average but there is an almost even split between positive and negative returns. That tells me that the result is much less robust.

Needless to say, I’m very cautious going into the rest of the trading week. I think the market has zoomed back to the January highs but at the cost of a very bullish option sentiment. If you’re a contrarian, you just can’t ignore something like this.

I’ll have more about this on Friday, during our usual overview of weekly sentiment data.

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7 Responses to “Option Traders Reach For Gains, Forget Risk Completely”  

  1. 1 jesuscheung

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    i still think your ultra bullish article on “Why Extremely Lopsided Volume Days Are Bullish” overrules this seemingly bearish article. hence, 3, 6, 12 months, higher S&P to go!

  2. 2 Babak

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    jesuscheung, yes, well, I thought that I was clear that this was for the short term. We’ll see in either case how things shake out eventually.

  3. 3 Wayne W

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    I have heard from other reputable sources that are concerned shortterm with the put call ratio as well. It would be interesting to look at how the ratio compares when we were at similar price levels on Jan 11.

    One of things that is on my mind this morning, is you posted some work by NDR, that suggest that the number of issues making new highs on a “weekly” basis normally peaks 3-6 months in advance of price. I only have the daily New high #s but notice that

    Last three days, New Highs and New Lows have been

    100305 458 01
    100308 467 06
    100309 432 04

    At mid morning we already have 300 new highs and zero new lows and that number will expand throughout the day as long as price is positive.

    When the market peaked on Jan 11th, they had been running

    100106 451 1
    100107 342 3
    100108 382 4
    100111 523 1

    It would be very unusual for us to go straight through the old cash high of 1150.23 . Some will use the retest of old high as excuse to move to the sidelines but if we are meant to go higher, we will eventually work through it.

  4. 4 Fibocycle

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    Interesting observation Babak. When doing my data massage last evening I noticed that the ‘raw’ TRIN was @ .6078 which brought the 5 day TRIN SUM to 3.90–usually a warning of a market pivot. The 21 mvg ave of TRIN has not made any blatant warning signals–but I have noticed that the longer term TRIN tools have become somewhat ineffective. Could this be because of the nefarious dynamics of trading on Wall Street–or is my inherit cynicism clouding my judgment?

    Perhaps the indexes can maintain some strength and fulfill 1.618 ABC rallies of the Feb 5th low and form fibo harmonics from the Jan 11-Feb 5th range. March 17th would be harmonic with the culmination of a A-B-C rally at the following levels.

    S&P 400 801-802
    S&P 500 1153 - 1154
    COMP 2445-2465

    Perhaps the bear will peak his hungry head out of his winter cave on Saint Paddy’s Day.

  5. 5 Darth Trader

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    Beware the Ides of March!

  6. 6 Peter Tsang

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    Good analysis - I think the ISE sentiment index could be an effective indicator to identify short-term trend exhaustions. I would be interested to observe the effects/market returns between say the first spike above 250 in say 6 months versus multiple spikes within say 6 months. This may be helpful in identifying where the market is in an intermediate term secular cycles. Thoughts?

  7. 7 chaitanya

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    interesting article. thanks ! If i remember right, the market peaked sometime October 2007, and interestingly, per table above, 10/29/07 is when we last see the ratio above 250 (before this week).

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