Option Ratios Urge Cautious Investing

My favorite measures of sentiment have always been the option ratios. Sentiment surveys measure what people are saying, but option ratios measure what people are actually doing. Currently, the option ratios are saying that we are much closer to the end of this rally than the beginning.

The chart above is the 21 day moving average of the ISE Sentiment Index. The higher the line on the page, the more calls are being bought. This measure of sentiment is now sitting at a 52 week high. The three other times that sentiment reached these levels were shortly before major legs down in the market.

This does not mean that the market must go down soon. In Bull Markets sentiment can go much higher than current levels. This only means that unless the underlying character of this market has changed, we are currently at a point where the market has run into trouble in the past year.

The chart above is the 30 day moving average of the CBOE Put/Call ratio. The lower the line on the page, the more calls are being traded. This sentiment index is approaching a 52 week extreme which is another warning signal for the market (although the line is likely headed lower for the next six trading days).

This coming week is a seasonally strong period and there is still room for the CBOE 30 Day MA to go lower. The market still has a window in which to rally but that window is closing quickly.

The S&P 500 currently trades at approximately 15% below its fair value. At times like these I prefer to look for reasons to buy, but the extreme in sentiment is too glaring for me to ignore. There are some differences between now and the past few times these sentiment indicators were flashing red. Sentiment surveys are not confirming the bullishness of investors and the Federal Reserve was not engaging in quantitative easing the past few times as they are now. However, it is troubling that investors are getting bullish even though the market is just churning. I am treating this market as being guilty until proven innocent.

Disclosure: None.

Comments

[SameerR:]

I completely agree.. ! I believe the expectations for a first-quarter rally are stretching a bit too far and that will end up being our fuel on the downside..

another note: I've noted a hefty amount of downside deep out-of-the-money puts on the spy (s&p spdrs) being bought on the front-month contracts over the course of a week..possibly accumulation due to low relative probability--just another clue of things yet to be seen

2008 Dec 30 05:33 AM

[SLAR250:]

Under normal volume conditions this is an excellent contrarian measure for future price action of the marketplace. By contrarian, yesterdays 206 reading indicated a large amount of opening call purchases, would send out an alarm for lower valuations- usually in the next 3 trading sessions. However, the ISE only had 1.6 million contracts hit the tape yesterday compared to its annual ADV of about 3.9 million. Light volume and a few large opening SPY trades skewed this number considerably discounting the value of the ISEE Sentiment reading yesterday.

2008 Dec 30 11:23 AM

[Rob Viglione:]

For anyone who is going long equities, I recommend hedging with VIX calls. Like the author, I'm treating these markets as being guilty until proven innocent.

2008 Dec 30 11:59 AM

[Roger Knights:]

I like the cautious, balanced way the author presented his case.

2008 Dec 30 01:00 PM

[sr9web:]

Good article - good comments too!

2008 Dec 30 01:57 PM

[User 366367:]

Though this article seems to be accurate in its content, i was just wondering if one could completely and plainly rely on ISE sentiment index and CBOE p/c ratio. Though i am not a great options person, from what i understand of options a call option would include NOT just LONG Calls, but also those SOLD their calls. And at the end of the day, when you look at the total CALLS, would it not include BOTH bulls and bears. If this is the case, then how can we rely on this metric if it is not truly showing if the underlying sentiment is 100% bull or bear?

May be i am missing something, but any comments would be great.

Thanks

Feb 28 02:26 PM