Equity Put/Call Ratio at 41-Month Low, but Risk of ‘Black Swan’ Event Limited

Last week the CBOE Equity Put/Call ratio slipped as low as 0.43, the lowest level since January 2011. Similar readings in April 2010 and April 2012 led to nasty sell offs? But something is different this time.

Last week the CBOE Equity Put/Call ratio plunged to 0.43, the lowest reading since January 2011. This wasn’t just a one-day fluke as the 5-day SMA fell as low as 0.518, also a 41-month extreme.

A ratio of 0.43 means that option traders bought 2.3 calls (bullish option bet) for every put (bearish option bet). Option traders don’t have a ‘smart money’ reputation.

The chart below, featured in the June 11 Profit Radar Report, plots the S&P 500 (SNP: ^GSPC) against the 5-and 10-day SMA of CBOE Equity Put/Call ratio.

As the dashed red lines highlight, low put/call ratio levels led to S&P 500 (NYSEArca: SPY) weakness more often than not.

Is the Put/Call Ratio Warning of a Crash?

Lately, there’s been much talk about a crash or major correction. Does the current equity put/call ratio foreshadow such a crash or correction?

Looking at the put/call ratio in isolation one could conclude that there’s a high chance of a 1%+ correction. Why?

Similar equity put/call ratio readings in April 2010 and April 2012 were followed by nasty sell offs (see red shadows).

But let’s expand our analysis to include the CBOE SKEW Index. The SKEW Index basically estimates the probability of a large decline (2 standard deviations or ‘Black Swan’ event).

Readings of 135+ suggest a 12% chance of a large decline. Readings of 115 or less suggest a 6% chance of a large decline. In short, the higher the SKEW, the greater the risk for stocks.

Last week the SKEW finished at 127.78, which is above average, but well below its January peak of 139.62.

The April 2010 and April 2012 highs saw SKEW readings of 134 and 139 (shaded areas).

The relative SKEW anemia softens the generally bearish message of the put/call ratio, but it doesn’t eliminate all the risk.

The Profit Radar Report’s 2014 S&P 500 Forecast (published on January 15), projected a pre-summer high at S&P 1,950. Last week the S&P reached 1,950 and pulled back. What does this mean for the rest of the year?

A complimentary look at the updated 2014 S&P 500 Forecast is available here:

Updated 2014 S&P 500 Forecast

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Indicator: Risk of ‘Black Swan’ Event is Elevated

On February 14 we highlighted a ‘big fat’ buy signal. Now we are looking at a possible ‘Black Swan’ alert. This indicator was designed to sniff out big drops and although we may not be looking at a ‘Black Swan’ sell off, it suggests risk is rising.

On February 14, I wrote about a ‘big fat’ buy signal (New Spin on Old Indicator Gives Big Fat Buy Signal).

Now this ‘big fat’ buy signal is met by an indicator that suggests elevated risk of a serious decline (‘Black Swan’ event).

Which indicator measures the odds of a ‘Black Swan’ event?

It’s the CBOE SKEW Index.

The SKEW Index is calculated by the CBOE. The CBOE is also responsible for the VIX (NYSEArca: VXX).

According to CBOE, the SKEW is designed to measure the tail risk (= risk of outlier returns two or more standard deviations below the mean) of the S&P 500.

The SKEW Index basically estimates the probability of a large decline or ‘Black Swan’ event.

Similar to the CBOE VIX or VIX Volatility Index (Chicago Options: ^VIX), the price of the S&P 500 tail risk is calculated from the price of the S&P 500 out-of-the-money options.

The SKEW typically ranges from 115 to 135. Readings of 135+ suggest a 12% chance of a large decline (2 standard deviations). Readings of 115 or less suggest a 6% chance of a large decline.

The chart below shows the SKEW readings since January 2012 and plots them against the S&P 500 (SNP: ^GSPC).

On Friday the SKEW jumped to 138.79. This isn’t the top tick (December/January saw 139.62 and 143.20), but it’s higher than 99.5% of all other readings since January 2012.

The red lines highlight that elevated SKEW readings (such as 138+) translate into limited up side potential and increased down side risk.

The SKEW is very helpful, but should be combined with other facets and forward-looking analysis.

The December 20, 2013 Profit Radar Report (Sentiment Picture) put the message of the SKEW in context with other indicators and forecasted the following:

“Bullish sentiment will catch up with stocks in January. This should cause a deeper, but also temporary correction.”

The S&P 500 and S&P 500 ETF (NYSEArca: SPY) saw a ‘deeper but temporary’ correction and price and SKEW are basically back to where they were in January.

More up side is possible as long as the S&P 500 can stay above support, but the SKEW suggests that the up side is limited and any gains to be erased eventually.

A unique analysis of another popular indicator cautions that the SKEW’s message may be valid:

MACD Did Not Yet Confirm Stocks Up Trend

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.