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Put/Call Clarity


No Respect!


John Succo mentioned yesterday in Buzz & Banter that in his opinion, those who were bullish on the market still are even after the decline we've seen. One of the arguments against his opinion is the high level of several put/call ratios available from the Chicago Board Options Exchange (CBOE) and on many quote systems. But those ratios may not be the most accurate of contrary guides.

Put/call ratios show the proportion of put volume to call volume. The traditional interpretation is that high put volume relative to calls (i.e. a high put/call ratio) shows a scramble for protection from those who think the market will be going lower, and when it becomes extreme, the market usually does its best not to reward that type of behavior and it rallies. In contrast, very low put/call ratios show a preference for calls that is normally unwarranted as the market frequently declines after such displays of optimism.

There are several problems with the put/call ratios that many rely on as a gauge of investor sentiment. The biggest issue is that we don't know WHO is making up the volume. Is it thousands of small traders taking two or three contracts at a time, or is it just a few institutions scooping up tens of thousands of contracts? Also, we don't know WHAT the traders are doing - are they buying these contracts to open or selling them? That is a crucial distinction, since buying or selling an option contract to open has vastly different risk/return characteristics. Unfortunately, there is no easy way to know the answers to these questions from the information disseminated from the CBOE and most quote systems.

On a weekly basis, however, this information is released to the public by the Options Clearing Corporation. Dissecting the data a little, we can virtually eliminate the issues mentioned above with traditional put/call ratios. The data given by the OCC allows us to narrow down the volume by trade size, as well as whether the contracts were bought or sold to open. What we want to do is find out what the smallest of traders are doing, since they unfortunately are the ones most likely to lose their money. By knowing what they are doing, we can do the opposite and hopefully profit, or at least take precautions against losing.

For the latest week, let's look at the smallest of options trades - those for 10 contracts or less, which amount to an average of $200 to $2,000 per trade. Let's further narrow our search by looking at only those contracts that were bought to open. By going through these two steps, we can find out who (the smallest of traders) is doing what (buying options). Last week, these traders bought 693,931 call options to open, which is a bet the market will rise. While there are hundreds of strategies using call options, remember that we're talking about very small traders - I think it's highly unlikely these are part of large, complex trade strategies. For the same week, these traders bought only 300,489 put options to open. This gives us a put/call ratio of 0.43, and is something we have dubbed the R.O.B.O. Put/Call RatioTM (for Retail-Only, Buy to Open). While we only have data going back to 2000, a ratio of 0.43 is very low, and is surprising given the drop in the market and the high put/call readings from the CBOE.

The chart below puts the current reading into context and shows us that among these smallest of traders, we are not seeing nearly the type of fear we have seen at prior intermediate-term lows, and not even what we saw in the Fall of last year.

This is only one measure, it has a limited history and it is certainly not infallible, but when trying to estimate the psychology of the crowd, it helps to have as much evidence on your side as possible. As of last week, the bulls should not point to small-trader option sentiment as a point in their favor.

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No positions in stocks mentioned.

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