Is a Market Top Near? ‘Smart’ Option Traders Send a Curious Message

Option trader sentiment extremes have racked up a fairly impressive track record as a contrarian indicator in the Fed’s QE bull market. No one else is talking about a major market top, so now might be an appropriate time to ‘check in’ with option traders and see what they have to say.

The QE bull market is 53 months old. The S&P 500 trades 156% higher today than at its March 2009 low, the Nasdaq-100 and Russell 2000 are up 209%.

No one else in the mainstream media is calling for a top, which is all the more reason to open this particular can of worms: Is a market top near?

One specific segment of traders has offered valuable clues about approaching market tops in the past: Option traders.

Equity Put/Call Ratio

The Equity Put/Call Ratio and SKEW Index capture the actions of the kind of option traders considered ‘dumb money’ (please don’t shoot the messenger, I didn’t come up with the term).

The Equity Put/Call Ratio shows the put volume relative to call volume. A ratio above 1 occurs when put volume exceeds call volume. The ratio is below 1 when call volume exceeds put volume.

Puts are bought to protect portfolios against declines; calls are bought as a bet on higher prices.

Since this is a contrarian indicator, high readings (0.9 or above) are usually seen near market bottoms when fear of a decline runs high. Readings around or below 0.5 reflect a dangerous extent of complacency and occur near market highs.

Last week the Put/Call Ratio fell as low as 0.55%. What does that mean?

The chart below plots the S&P 500 (NYSEArca: SPY) against the equity Put/Call Ratio (bottom of chart) and the SKEW Index (more about the SKEW in a moment).

The vertical red lines highlight readings at market tops.

When viewed in the context, the current Equity Put/Call Ratio is approaching a level that’s caused trouble for stocks in the past.
This note, which I sent to subscribers on April 16, 2010 explains exactly why: “The put/call ratio can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses accrued by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.
This note preceded the 2010 ‘Flash Crash’ by only 13 days.
The current reading doesn’t foreshadow a Flash Crash, but a degree of caution is warranted.
SKEW Index
Like the VIX, the SKEW is calculated by the CBOE. The SKEW is far less popular than the VIX, but has delivered much better signals than the VIX lately.
The SKEW Index in essence estimates the probability of a large decline. Readings of 135 suggest a 12% chance of a decline. Readings of 115 suggest a 6% chance of a large decline (large decline is defined as a two standard deviation move).
In other words, low extremes are bullish for stocks; high extremes are bearish for stocks.
As the chart shows, the SKEW is currently in ‘bullish for stocks’ territory.
This contradicts the more or less bearish message of the Equity Put/Call Ratio.
What do we make of this?
Past experience has taught me not to bet against the SKEW. It’s prudent to allow for higher prices, perhaps after a shallow correction.
To get the best possible read on the stock market, I look at sentiment (such as options data and other sentiment/money flow gauges, seasonality and technical signals.
Right now the technical picture for the Nasdaq-100 (Nasdaq: QQQ) is fairly crisp and clear. The Nasdaq-100 is moving towards serious resistance in a well-defined trend line channel. This resistance increases the odds of a sizeable top dramatically.
Simon Maierhofer is the publisher of the Profit Radar Report.
Follow Simon on Twitter @ iSPYETF

 

Despite Crazy Run and New Highs, Immediate Flash Crash Unlikely

The S&P 500 is up 15% since mid-November, while the Dow rallied to never before seen highs. Something that’s just too good to be true with a wink-of-the eye implication that another Flash Crash type event is brewing. What are the odds?

What goes up must come down. We’re all aware of this fact of life. The question is, when will stocks come down and how fast and far will they come down?

There’s been some talk about another Flash Crash event, so I wanted to check out how likely another Flash Crash-like event is right now.

The price action leading up to the May 6, 2010 Flash Crash is illustrated in the first chart below.

Note that the ominous May 6 sell off happened eight trading days after the April 26 high. By the time May 6 rolled around, the S&P 500 had broken below two support levels (green lines). It also broke out of a triangle formation.

The basic recipe of events (time lag between top and waterfall decline, break below support levels) also led up to Black Monday, the fateful day that saw stocks crash in 1987.

Another clue leading up to the 2010 high was an extremely low equity put/call ratio. In a note to subscribers on April 16, I warned of the following:

“The message conveyed by the composite bullishness is unmistakably bearish. The put/call ratio in particular can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses occurred by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.”

The equity put/call ratio is currently in neutral territory and the S&P 500 just posted a new top tick yesterday. The S&P would have to drop below initial support at 1,540 first. This would have to be followed by a break below key support.

The time lag between a new high and break below support should give investors enough time to turn defensive.

Seasonality suggests that the time for a Black Swan sell off is not (yet?) ripe. ‘Sell in May and go away’ has been a good strategy in most recent years, especially in 2010. March/April seasonality is not nearly as bearish as May.

In summary, the risk of an immediate Flash Crash type event is negligible, but that doesn’t mean that prices will only go up.

The potential for a Black Swan event and larger decline becomes greater if we zoom out of the very near-term into the mid-and longer-term timeframe.

Exactly How Worrisome is Bullish Sentiment?

Contrarian investors love to use sentiment as a general overbought/oversold measure. There’s no denying that Wall Street and Main Street have surrendered to the allure of higher prices, but just how much of a threat does bullish sentiment pose right now?

If you have skin in the game, you probably know something about the game.

If you have money invested in stocks, you probably have noticed the increasingly bullish forecasts.

Sentiment is a valuable contrarian indicator, but exact danger levels are difficult to quantify. How worrisome is the current bullishness?

Inverse Contrarianism

We saw a rare phenomenon in early January. Investors turned bullish, but the media publicized the bearish implications of bullish investors.

The January 13, Profit Radar Report pointed out the following: “Last week’s most notable development is the uptick in investor optimism. This normally contrarian development is tapered by the unusual media attention.

A headline on the Yahoo!Finance homepage reads: ‘Is the crowd’s cheery mood reason to fear the rally’s end?’ CNBC published articles such as: ‘Why the VIX’s recent plunge may be bad for stocks’ and ‘Where is the wall of worry?’

A contrarian indicator with so much mainstream attention is not contrarian anymore. Hopefully a continued move (perhaps through a laborious process) to around 1,490 will silence the contrarian publicity and better align overall sentiment with our upcoming technical short setup.

Market Silenced the Media

The S&P 500 has rallied 40 points since mid-January and did indeed silence suspicious media outlets.

Now we see headlines like these:

CNBC: Market Bears on The Brink: ‘I Can’t Fight Anymore’
CNBC: S&P 1,500: Last Barrier Before New Record
Reuters: The Great Rotation: A Flight to Equities in 2013
Bloomberg: Nouriel Roubini Faces the Music: Did Dr. Doom get it Wrong?

This is the most bullish I’ve seen the media in well over a year, but admittedly my self-composed “Headline Sentiment Index” lacks the trackability needed for a good indicator.

Other sentiment gauges do have a long track record and the Profit Radar Report takes a detailed look at four of them every month.

Below is the January 2013 Sentiment Picture (the Profit Radar Report prepares one detailed Sentiment Picture per month for subscribers on record).

Like gauges in your car’s instrument cluster, the monthly Sentiment Picture provides a quick summary of what’s going on.

Illustrated are the CBOE Volatility Index (VIX), Equity Put/Call Ratio, the percentage of bullish advisors/investors polled by Investors Intelligence (II), and the American Association for Individual Investors (AAII).

Shaded red areas denote the minimum/maximum sentiment extremes seen at prior highs.

Here’s a quick rundown of the four indicators:

The VIX is in danger territory (red box).

The Equity Put/Call Ratio is not per say in danger territory, but not far away from where a market top could be.

The percentage of bullish advisers polled by II is getting in the red danger zone.

The percentage of bullish investors polled by AAII is in the red zone.

Summary

Investor enthusiasm is high enough to where it could cause a sizeable correction, but not extreme enough to force a turnaround. A break below support would probably elicit more selling.

And one thing is for sure, there are plenty of buyers that could turn into sellers and drive prices lower. The Profit Radar Report pinpoints the support levels that, once broken, will cause more selling.