As we plunge into the second half of this year, the alleged home of the die-hard bulls? fabled Second Half Recovery, one grand question continues to perplex index speculators. Have we just witnessed yet another doomed bear-market rally or the birth of a new cyclical or secular bull market?
While the new long-term secular-bull-hypothesis case is unbelievably weak due to the stellar
overvaluations still rampant today, strong arguments exist for both the bear rally and medium-term cyclical-bull theses.
Although no mere mortal can know for sure which kind of market we are sojourning through these days until after the fact, the crux of the index-speculation game today involves weighing the odds and making a decision between short-term bear rally or medium-term cyclical bull.
If we have just witnessed a particularly potent bear rally, odds are the best short-term plays at the moment are to the short side as it fails. On the other hand if we are still in a maturing medium-term cyclical bull the markets could run yet higher before the secular Great Bear primary downtrend reasserts its crushing dominance with a vengeance.
As we ponder these strategic speculation questions at Zeal, I have been examining an intriguing subset of the famous Put/Call Ratio. As I mentioned a month ago in ?Trading the Put/Call Ratio 2?, in addition to the headline PCR everyone follows there are also pure narrow index-specific PCRs for the elite indices. Can these pure PCRs help speculators execute superior index trades?
The usual PCR, or the ?headline? PCR, is calculated by dividing the total put volume traded in a given trading day by the total call volume traded on the
Chicago Board Options Exchange. This headline number includes all of the CBOE-traded options contracts, including stock options and stock-index options. While I continue to believe that the headline PCR is a very valuable contrarian sentiment indicator for all speculators to monitor, it is not without issues.
Stock-index speculators, naturally, only really care about the collective options trading activity directly related to the major stock indices. For example, what do bond-yield options, foreign-stock-index options, or oil-stock-index options really have to do with trading the primary American indices? Not a lot! Wouldn?t it be nice to drill down on a pure PCR that only reflected options directly relevant to index traders?
Granted, the headline PCR is utterly dominated by various flavors of options on the major US stock indices, but speculators often choose to specialize in trading only a few of these. Some folks including me like the
QQQ options for index speculations, others like Dow 30 options, and still others play the game primarily in S&P 500 options.
The headline PCR lumps all these different types of index-options activity together into one grand summary number. This is fine most of the time since the major stock indices tend to be very highly correlated to each other through time, but occasionally it would be nice to focus exclusively on one specific type of index-options activity.
For example, in the recent rally the tech darlings have seen far greater advances than the blue-chip Dow 30. Rather than combining both the hyper-risky NASDAQ 100 and conservative Dow 30 into one single headline PCR number, wouldn?t it be interesting to know how options speculators are playing each individual index? Can aggressive indices combined with conservative indices obscure what is really happening under the surface in each? Will valuable insights be revealed looking at pure PCRs that are not evident in the summary headline number?
After examining pure PCR data for various indices for several weeks now, I know the answers to these questions are definitely yes. The headline PCR is a wonderful indicator and will always be rightfully revered by speculators, but there is a whole other world of great insights available by digging deeper and analyzing the pure index-specific PCRs as well.
This week I would like to begin our official explorations into this arena by taking an initial look at the pure QQQ-only PCR as well as its potential implications today for index speculators.
Just as the headline PCR is calculated by dividing total put volume by total call volume, the pure QQQ PCR is computed by dividing total QQQ put volume by total QQQ call volume on any given trading day. Please realize that these are volume-based calculations, not open interest!
For some unknown reason I have seen quite a few people confuse this lately, trying to calculate a PCR based on OI instead of volume, which is absolutely wrong. While volume is a simple turnover measure, the number of contracts traded in a given day, open interest is an entirely different beast. OI is the total number of contracts outstanding at any given time, very different from daily trading volume. OI is a strategic snapshot frozen in time of all open positions while volume is a measure of contracts traded over one trading day.
We included Put/Call Open Interest Ratios (PCOIRs) in the graphs below to help contrast them with the true PCRs. Unlike the PCR, the PCOIR is calculated by dividing put open interest by call open interest. PCOIRs, which only change slowly over time, are also vastly less volatile than the PCRs. The PCOIRs are interesting and probably useful, but they are very different from the PCRs and shouldn?t be confused as such.
Before we delve into the pure QQQ PCR and its implications for speculators, it is important to take a few minutes to do a quick review of the headline PCR itself. As always we are using the 21-day moving average of the headline PCR in these graphs to help smooth out the raw ratio?s phenomenally wild volatility. The pure QQQ PCR is most illuminating when contrasted with the headline PCR that so many speculators are already intimately familiar with today.
The headline PCR is famous as a contrarian sentiment indicator. It reflects the overall greed and fear of options speculators as a whole and helps signal when one emotion or the other is getting out of hand. One of the oldest and most irrefutable principles of the markets is that the majority is almost always wrong. The most successful long-term way to trade is to take the opposite position from the majority most of the time as a contrarian and ride the inevitable mean-reversions back towards emotional neutrality.
As you can see above the headline PCR tends to move opposite to the indices. A high PCR, which indicates more general fear than greed as folks load up on puts, is only witnessed near market bottoms. At the very pits of popular despair when folks should generally be bullish, like the contrarians, is when they start expecting The End of the World and put buying soars. So a prudent contrarian speculator fights the crowd and throws long by buying calls when everyone else is buying puts.
Conversely a low headline PCR signals that popular greed is far greater than fear as folks rush to buy calls. These very moments of glowingly rosy expectations and smug complacency are only witnessed near market tops. After a major rally most people eventually expect the markets to rise into infinity, so they load up on call options. A prudent contrarian speculator, however, bucks this sheep-like behavior and throws short via put options when everyone else is buying calls.
As I mentioned at the beginning of 2003 in ?Trading the NASDAQ Bust 2?, the headline PCR?s best signals tend to be the shorting ones marking major interim market tops. The vertical white arrows in the chart above mark these moments in time when the PCR fell to the bottom of its uptrend channel and signaled speculators to go short in the face of unsustainable popular greed and complacency.
Interestingly these shorting signals were absolutely perfect until Washington annexed Iraq in March and unleashed a massive rogue sentiment wave of unbridled greed. Since mid-March, the headline PCR has touched the bottom of its long-term uptrend channel three times and each failed to be a good shorting signal. These recent PCR anomalies, along with the reasons behind the overarching strategic PCR uptrend, are discussed in much more detail in ?Trading the Put/Call Ratio 2?.
While most of this graph is necessary review, the yellow Put/Call Open Interest Ratio line rendered above is totally new. Rather than showing a 21-day moving average of the volume-based PCR, the PCOIR instead illustrates the ratio between outstanding puts contracts and outstanding call contracts. Since open interest changes slowly and isn?t very volatile, it doesn?t require moving-average smoothing. While quite a different animal from the PCR, the PCOIR also offers some revealing insights for speculators.
Like the PCR 21dma the PCOIR is gradually rising throughout this primary bear market. Slowly but surely the Great Bear is relentlessly doing its thing and gradually knocking it into the thick skulls of investors that valuation matters, that buying any stock at any price is foolish. I suspect the PCOIR will continue to increase all the way into the ultimate Great Bear bottom, as the ratio of bears to bulls is steadily growing as people gradually begin to understand what financial horrors a supercycle bubble and bust truly entail.
While the general strategic upslopes of the PCR 21dma and PCOIR are similar, it is important to note the huge differences in these loosely related datasets as well. While the PCR has tradable troughs and peaks, the PCOIR is just a series of static snapshots of outstanding puts and calls held by the bears and bulls. It is no doubt interesting to look at occasionally, but the smooth PCOIR is certainly not a fantastic tactical trading tool like the PCR. Don?t confuse these ratios!
With the benefit of an overview of the headline PCR and its strong contrarian nature under our belts, we can now begin exploring the pure QQQ PCR. The pure QQQ PCR, as its name suggests, is calculated solely by dividing QQQ put volume by QQQ call volume traded in any given day. It offers a valuable untainted glimpse into the psychology and bets of QQQ NASDAQ 100 stock-index traders alone.
Following convention, we used a 21-day moving average of the pure QQQ PCR to smooth out its extraordinary volatility. The yellow QQQ PCOIR shown is raw though as it doesn?t change fast enough to require smoothing. The dark gray line is the usual summary headline PCR 21dma from the graph above, drawn in for comparison purposes to help highlight the enormous QQQ PCR volatility.
Before I saw this graph, I had assumed that the pure QQQ PCR would track the headline PCR relatively closely. I also assumed that it would be a similar contrarian indicator, that prudent speculators would have to do the opposite of the QQQ herd in order to have a high probability of realizing successful trades. Boy was I wrong! The QQQ-only PCR has a totally different character than the headline PCR, a big surprise. These revelations are causing me to reassess my perceptions of who the majority of QQQ-options speculators really are.
It?s certainly hard to believe, but amazingly enough the pure QQQ PCR is more of a concurrent indicator than a contrarian indicator! Rather than moving in virtual lockstep opposition to the underlying QQQs like the headline PCR, this QQQ-only PCR managed to track the NASDAQ 100 and QQQs remarkably well. The implications of this surprising revelation are startling.
Instead of trading against the QQQ-options-trading majority, speculators will note that the best gains have usually been made trading with this particular crowd. The pure QQQ PCR tends to be highest near major interim tops and lowest near major interim bottoms! Strange.
The low QQQ PCR ahead of major interim bottoms means that relatively more calls were being traded than puts, driving the ratio down. One possible interpretation of this observation is that QQQ-options traders, as a whole, were
anticipating the interim bottoms due to the rapidly plunging stock markets, distinctly contrarian behavior! Unlike the headline PCR, the QQQ PCR wasn?t lowest near the tops, but near the bottoms!
Conversely, the QQQ-only PCR peaked after major interim tops, also implying that the majority of QQQ-options traders were anticipating a coming downleg! For some reason the QQQ PCR has tended to move with the QQQs instead of opposed to them like the headline PCR. This general behavior is quite evident in the entire history of the detailed QQQ options trading data available from the CBOE, which is all graphed above.
I have been pondering this for a couple weeks now and I still don?t quite know what to conclude about the QQQ PCR. Obviously the majority of QQQ-options players understand the nature of the game quite well and they are more than willing to buy puts when the markets are high and buy calls when the markets are low, definite unmistakable contrarianism at work!
This really challenges my perceptions about what kinds of speculators and hedgers are actually at work in the QQQ options arena.
While I have long thought that QQQ-options land was dominated by individual speculators, who are collectively notorious for trading with the mainstream crowd and ignoring contrarian discipline, perhaps this isn?t the case. If small speculators were the driving force, the QQQ PCR should look much more like the headline PCR, with the small speculators generally taking the exactly wrong positions at major interim topping and bottoming extremes. This certainly isn?t happening in the chart above constructed with the data direct from the CBOE!
Instead of playing QQQ options, maybe the majority of usually wrong small speculators are playing the underlying QQQ stock and other tech darlings directly. If you are a tech bull today who believes that it is perfectly normal and even intelligent to buy mature companies at 40x+ earnings, you probably are buying tech stocks outright or leveraged via margin accounts. Buying stocks directly is much easier and vastly less risky than playing call options, so perhaps heavy small-speculator influence is relatively absent from QQQ options trading.
Maybe more sophisticated speculators are playing the QQQ options, willing to leverage their capital with options because they fully understand the large risks involved. Once a speculator has paid his or her dues long enough to amass serious capital, odds are that he or she has made most of the typical mistakes and has already learned the hard way to trade opposite to general market sentiment. The QQQ PCR line above seems to reflect a sophisticated understanding of the nature of markets that we would expect to see from large speculators.
Another possibility is hedger dominance of the QQQ PCR. If a large institutional investor has heavy long exposure in the NASDAQ 100 or major companies anchoring it, the institution may want to hedge its bets in case it is wrong
on index direction. The way to hedge long positions is to buy puts. These puts allow the institution the comfort of being able to sell its NASDAQ 100 investments at set prices for set periods of time in the future regardless of prevailing market conditions.
If this is the case, we would expect to see high putting activity when the NASDAQ complex is high and low putting activity when it is already low. And indeed, the graph above shows exactly this phenomenon. Institutional players like tech hedge funds with large long positions in tech stocks may be hedging their macro bets by layering on huge QQQ puts positions to protect their profits after the periodic rallies in tech-land.
While this is all conjecture and I don?t know who is dominating QQQ options trading, I can see in the graph that they are good at what they do. Put volume soars near interim tops and call volume soars near interim bottoms, exactly the way contrarians play this grand game. While these signals aren?t precise enough to trade like the headline PCR, they offer great strategic insight into what the sophisticated QQQ options players expect to transpire in the markets next.
The QQQ PCR is also vastly more volatile than the headline PCR, shown above in dark gray. While the headline PCR?s range is generally between 0.5 and 1.0, the QQQ PCR has been all over the map, plunging under 0.5 and even challenging 3.0, an incredible level where the QQQ PCR 21dma indicates that three puts contracts are trading for every one call contract! The QQQ PCOIR also mirrors the enormous range of the QQQ PCR, utterly dwarfing the headline PCOIR. If you are a speculator who craves volatility, the QQQs are the place to play!
Provocatively, today the QQQ PCR 21dma is challenging its highest levels in history. While general stock-market sentiment is overwhelmingly greedy and complacent, whoever it is playing the QQQ options directly appears to be expecting an enormous downleg approaching. Past interim market topping zones in the QQQs have been marked by abnormally high putting activity driving the QQQ PCR higher. This latest QQQ PCR topping zone towers so much higher above the preceding ones that it is scary. What on Earth is approaching?
These QQQ-options players, maybe large speculators and maybe institutional hedgers, have amassed an impressive track record over the last couple years of QQQ options trading. They are heavily weighted to the long side near interim bottoms with calls and they load up to the gills on puts near interim tops expecting to profit or protect on the inevitable downlegs. With this level of market insight and performance apparent, today?s index speculators ought to carefully consider the implications of these massive puts positions being accumulated in QQQ options.
For whatever reason, these sophisticated QQQ-options players are positioning themselves for an enormous downleg in the next six months or so, the rough expiration time limit of non-LEAPS QQQ options purchased in the past couple months. Regardless of whether these are large speculators hoping for a short profit or large hedgers trying to protect their huge tech portfolios from downside risk, they are immensely skeptical of the recent equity rally.
In terms of the great bear-market-rally versus cyclical-bull-market debate, it certainly appears that the majority of QQQ-options players buy the short-term-bear-rally hypothesis versus the medium-term cyclical-bull-market-within-a-Great-Bear thesis. They have plowed an extraordinary amount of capital into QQQ puts in recent months betting that the bear rally is almost over and a major downleg is approaching.
Since they have been right on in the past when they chose to amass enormous puts positions and drive up the QQQ PCR ahead of a downleg, odds are they know what they are doing this time around too. They apparently expect the miraculous tech rally since mid-March to not only fail and roll over, but to fail hard and fall sharply. These large speculators and hedgers are apparently preparing for the worst.
Like the majority of QQQ-options speculators, I also believe that the short-term bear rally is topping and the next downleg will be vicious. We are patiently awaiting some specific technical shorting signals to add some aggressive new QQQ puts positions to our current options-speculation portfolios.
I discussed these approaching signals along with crucial passive and active risk management strategies for options speculators in the new July issue of our acclaimed Zeal Intelligence newsletter published last week. If you wish to join us, new e-mail PDF edition subscribers will be promptly e-mailed a complimentary copy of this current issue after subscribing. As this major top and subsequent downleg unfolds, our new QQQ options trades and always-evolving options strategy will be detailed in future issues of Zeal Intelligence for our subscribers.
Fortunes will be won and lost based on whether the markets are now topping after a major bear rally or still heading higher in a cyclical bull. While the general headline PCR shows great complacency and greed today, no worries, the pure QQQ PCR shows an extraordinarily high degree of pessimism on the NASDAQ complex.
And since the history of the QQQ PCR has shown that it is much more of a concurrent rather than a contrarian indicator, index speculators ought to pay attention and get ready. The majority of QQQ-options players have usually been right near the extremes and odds are they will be proven right again this time.
Adam Hamilton, CPA
July 11, 2003
