Tag Archives: options

Complacency still extreme

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Even if this is just a small correction in a continuing rally (which it is very dangerous to assume), the market has a lot of room left to shake things up. The 20-day average equity put call ratio is still at an extremely suppressed level:

Indexindicators.com

Here is the raw data since 2004, the last time we saw such a low running average of CPCE. Stocks went nowhere for about a year after that. They should be so lucky this time…

stockcharts.com

Such long-running lows must be balanced out with more than a bit of fear. One other thing that is noteable in this chart is how the Panic of ’08 only produced marginally higher put:call readings than the stagnation of ’04.

VIX cycles

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No strong conclusions here, just some food for thought:

c

Prophet.net

You can also see a possible 30-day pattern: 30 days down, then a ramp. Let’s put this in perspective. Here’s a 5-year weekly chart. All I can note here is a divergence on the RSI over the last few months:

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I’ve also noticed how Treasury bonds have resembled the VIX for some time (I put in those RSI buy/sell signals just for fun — not as effective here as in the 60-min chart of Dow futures, but not bad either):

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Just goes to show, when you think you’re trading US stocks, Chinese stocks, commodities, bonds and options, you’re really just trading global patterns of fear and greed. It doesn’t matter what market you choose these days. They’re all the same.

Options sentiment update

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The 5-day average equity put:call ratio is now right at the mean:

Source: indexindicators.com

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You can see that the 20-day average still has a long ways to go, which means that the 5-day is likely to spike well over the mean in the next wave (a 3rd wave?) down. I’m looking for summer 2007 conditions to counter the extreme complacency that we’ve had since August, which suggests that we have another 5-10% on the downside in this move after any countertrend bounce from here exhausts.

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As far as that anticipated bounce goes, the VIX also threw its hat in the ring, offering a buy signal by closing back within two standard deviations of its 20-day average.

Source: stockcharts.com

Suddenly, everyone wants puts!

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Gee, who would have thought?

Here’s the trusty 5-day trailing average equity put:call ratio as of Thursday’s close (for some reason, indexindicators doesn’t update this until the next morning). CPCE doesn’t give sell signals like last week very often, but when it does, SELL!  BTW, Friday’s closing CPCE print was 1.05, so this thing has really rocketed up now.

Source: indexindicators.com

This translates into some serious price changes, even on long-term options. The SPY 90-strike December 2011 puts I favor are up 40% in just a few days. I’ve also written a whole bunch of March-Sept 2010 calls on stuff like QQQQ and DIA. That’s a great way to make some income, since even if the market doesn’t crash, so long as it doesn’t keep blasting upwards the time decay is money in your pocket.

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UPDATE. Here’s the chart as of Friday’s close. I bet we don’t bounce hard until the 5-day average gets at least 1SD above the mean. And look at the swiftness of this week’s drop in SPX… this is a more powerful decline than any since last winter.

Party like it’s July ’07

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I have been watching the parallels between the last few months and the first half of 2007, and they are still very close. The late June – early July 2009 drop lines up with the late Feb – early March 2007 correction. In each instance, the markets then ramped up, then zig-zagged higher still as the put:call ratio oscillated at a low level. The final euphoric highs of July ’07 (when Chuck Prince said he was “still dancing” and Paulson said he had never seen such strength in the global economy) were marked by a brief lower low in CPC, which further compressed the springs for a stunning spike in fear as the equity markets cracked and Cramer threw a fit.

The crack here is likely to be even more violent, since everyone knows deep down just how bad things really are in the economy. It won’t take more than a shift in psychology to get people focused on the problems again, which are now fully developed, not just vague fears of some temporary “liquidity” issue in obscure debt instruments.

Source: indexindicators.com

The CPC does not linger at under 0.55.  Caution is creeping in already, as yesterday CPC made a higher print and the VIX, Russell and Nasdaq failed to confirm the Dow’s new high. The commodities complex may also be stalled out, and the dollar has corrected enough to continue far higher than in December. This time, the stars are aligned for an “all the same markets” rush to safety. Even Treasury bonds have sold off enough to rally nicely:

Source: Yahoo! Finance

Old Faithful

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The 5-day trailing average equity put:call ratio strongly advises selling stocks:

Source: indexindicators.com

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This average doesn’t stay below 0.55 for very long. This doesn’t mean that the indexes can’t squeak out new highs for a few more days, and it doesn’t mean they have to crash, but it does mean that a decline of at least a few percent is extremely likely to start with a couple of weeks.

Jason Goepfert of Sentimenttrader.com posted this chart of the American Association of Individual Investors bullishness survey on his blog:

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When everyone is on one side of the boat, stroll over to the other. In my opinion, at $6.00 each, December 2011 SPY 90-strike puts are just sitting there on the floor like $20 bills. The December 2012s are also now listed – the 100 strike is under 12 bucks today.

Blow-off tops everywhere

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Everywhere I look this morning I see spikes in risk assets: copper, silver, oil, the pound, stocks, credit, etc.  Copper and oil are moving tick for tick in lock step at the moment. These really are all the same market.

I recently read about a strategy whereby a trader would start “trading campaigns” 25k to risk on very high payoff black swan events. If his first short-term options trade was a winner, he would do another with the proceeds, and if that trade also worked, one more, for a total of three trades. The math can actually be highly favorable for of such a strategy, since for a good timer, the payoff can be dozens of times the initial capital. All you need is one winning streak in 10 or so campaigns to come out way ahead. This trader had attempted 9 such campaigns, 7 of which were 100% losers, 1 of which was flat, and one of which was a 60-bagger. He had socked away the proceeds from the 60-bagger, and was still trading 25k at a time. I’m not saying I’ll adopt this method, but it makes a good point about humans’ tendency to underestimate and underprice the probability of large moves, as well as their irrational risk aversion when it comes to the possibility of losing 100% in any one trade.

Optionality pays off.

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In the Goldilocks spring of 2007, by allocating 2.5% of one’s equity portfolio to December 2009 1000 strike puts on the S&P 500, a manager could have greatly reduced, if not eliminated the risk of the (then 4.5-year-old) bull market topping out over the next 30 months. The puts, even if not purchased at ideal prices, could very easily have appreciated by a factor of 10 as of today’s close, or even 20 if purchased on dips and sold last Friday.

At approximately $130 each, they could still easily appreciate by another two or three times by expiration if the bear market deepens.

It goes to show that it can pay to worry, even if you don’t have enough conviction to take decisive measures like liquidating a portfolio and going to cash (or short) while a bull market is still intact.

You can also insure against missing out on gains.

The same strategy can be applied on the long side. Suppose the Dow falls under 3500 by mid-2010 (actually, plan on it). Most people would by then have a perhaps unhealthy fear of stocks, just as they had an unhealthy attachment to them 18 months ago (and still do). The market could be approaching a turning point by then, but few will have the conviction to dive in with a significant portion of what is left of their capital.

In this case, our worrywart manager (who has since seen the light and bailed out of his stocks), if he gets another contrarian hunch, could risk just a few bucks for, say, December 2012 calls at 5000 on the Dow. Since he is still 97.5% in cash, if the market continues ever further into the abyss (distinctly possible this time), it is no big deal, but if stocks sport a classic recovery rally, the manager could get himself a very nice portfolio return.

The key to the lopsided risk-reward balance is to act contrary to popular sentiment when it has been running in one direction for several years. At such times, optionality on counter-trend moves is dirt cheap. I suspect that such an options strategy could generate very satisfactory long-term returns without ever risking more than three percent of principal.

You would not even have to own options all the time. You would just start buying puts after say, a three year and 40% gain in the S&P, and add to the position on rallies as the bull market matured, never allocating more than perhaps 1.5% of assets per year. Your sell trigger for the puts could be the moment the S&P records its first 20% decline.

Some inverse could of course be applied when the S&P is deep into a bear market. Bears often don’t last as long as bulls, so perhaps you would start to buy long-dated calls at the two-year mark or after a 30% decline.

That said, this particular bear is of the sort that hibernates for 300 years and couldn’t care less what all the other little bears have been doing while he was asleep. I am going to be very patient about waiting for him to exhaust himself, and may not to waste any ammo on him at all, but hunt the smaller game in Asia.