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Is Put Demand a Sign for the Bulls?


Gauging whether this is smart money -- or just nervous money.

While we were dozing in the midst of ever-declining volatility, it turns out there's been a little options buying going on under the surface. This from Bloomberg:

"Downside skew, which gauges the relative cost of buying insurance against a slide in stocks, is now higher than it was when the S&P 500 dropped to a 12-year low on March 9. That indicates a 'relatively high chance of downside moves.

"Global equity markets are beginning to falter after 3 straight months of gains in March, April, and May. The S&P 500 has retreated 5.4% since June 12, bringing an end to the benchmark's biggest 3-month rally in more than 70 years amid concern that the global recession may yet deepen.

" 'The sharp move higher in risky assets off the early March lows had pushed hedging to the back burner,' a team of analysts led by New York-based Sivan Mahadevan writes. 'Downside skew has risen recently, implying that the probability of large negative moves is actually somewhat higher.' "

If this is in fact the highest skew since March, I would agree it signals demand for out-of-the-money (OTM) puts. (That's the definition of why skew would lift).

But let's think about it for a second. The analysts assume there's an increased probability of a negative move. But why? Because someone is buying puts? Looked at another way, isn't this actually bullish? Why do we assume that the buying is being done by smart money rather than nervous money? Why can't this just be a relatively sensible and innocuous insurance buy against a good quarter?

The bottom line -- as my friend Don Fishback always reminds me: We just don't know the answer to any of these questions. All we know is that put demand increased, which -- without any other information -- is actually bullish.

And as long as we're on the subject, the chart here shows a ratio of the VIX to the VXO. The VIX incorporates every near- and/or second-nearest-month strike in its calculation until it hits 2 with no bids. So it picks up lots of at-the-money puts and incorporates skew in its formula.

The VXO -- which, unlike the VIX, is an options-based exchange -- just takes a few near-money strikes. Theoretically, this ratio should hit a high when skew is most pronounced. Yet it troughed in March, which seems to make little sense.
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