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As the Dow is set to close out its ninth straight week of gains -- a feat unseen since 1995 -- the put-to-call ratio on the CBOE skyrocketed yesterday. ETFs, stocks, index options ... you name it, all were up, and there was probably a ton of put buying.

CBOE Put Buying Imbalance
The $CPC, an index that measures the put-to-call ratio on just index options, surged to a high of 3.1 at 2 p.m. EST Thursday -- its highest level in over four years. A 3.1 reading means there were 3.1 puts being purchased for every call bought. Again, the $CPC only tracks options being purchased on the various indices. The index ended up closing at a multi-month high reading of 2.02.

The $CPCE, on the other hand, tracks the collection of option activity on individual stocks. For example, it would track options purchased on IBM, Amazon (NASDAQ:AMZN) or Intel (NASDAQ:INTC) but not on the SPY or QQQQ. The $CPCE has surged to inter-day levels unseen since the May flash crash. The index ended up closing off its highs to 0.56.

The $CPC is the index that tracks the put-to-call ratio on the entire CBOE, which gives us a sense of how investors are positioning themselves overall in the markets. The $CPC surged to as high as 1.31 in the early morning session Thursday, which was the highest level we've seen since this past May. The index ended up closing far off its highs at 1.02 -- still very high by most standards. It means that overall there were slightly more puts to calls being purchased on Thursday, which is generally abnormal. It's usually the case that far more calls than puts are purchased.

SPY Options Activity
Put buying on the SPY for the February expiration has reached extremes. Investors were purchasing hundreds of thousands of puts all the way down to the $118 level for the February 18, 2011 expiration yesterday. That's a mere 15 trading sessions away. Over 250,000 puts were traded on the $125 strike versus a mere 15,000 calls being traded at the $130 strike. All the activity was on the put side Thursday. There was also very heavy volume on the $127 and $123 February puts, with 145,000 and a 123,000 options being traded at each of those strikes respectively.

QQQQ Options Activity
Options activity on the Nasdaq 100 was far more contained than on the SPY. The heaviest volume on the QQQQ was on the February $57 strike, with 41,000 contracts exchanging hands. There's notably high open interest at both the $56 and $55 strikes with over 200,000 contracts open. The VIX held up very well, considering the 15-point move higher on the Nasdaq on Thursday.

Collapse or Huge Rally?

The big question with regards to this data is how should this put-to-call ratio imbalance be interpreted? It is not unusual to see very high put buying at market bottoms, where extreme fear hits a fever pitch, and right before the market is about to go into huge rally mode.

Where we generally don't see extreme put-to-call ratios, interestingly enough, is at market tops. In the vast majority of cases, we only see this type of activity at market bottoms or in mid-cycles as a form of hedge. Oftentimes we'll see a big put/call imbalance as investors choose to purchase cheap volatility ahead of buy programs in the market. This is especially the case with put buying on the SPY, as market participants opt to secure their positions with insurance on the broader market.

What is interesting about this activity is it comes right on the heels of news that $200 billion of extra excess liquidity will enter the market as early as the first week of February, nearly doubling the buying power of QE2 for at least the months of February and March. Moreover, what makes this activity very peculiar is the fact that the Federal Reserve in its FOMC statement yesterday all but declared that it won't allow the markets to see any significant selling pressure until at least the end of June. At that time, the Fed will probably extend its buy program with QE3 or QE Lite as it tapers the market off this artificial buying power and hopes that this rally is self-sustaining.

Thus, based on the fact that the Federal Reserve is doing everything in its power to back-stop the financial markets, I think it is more likely that this option activity is a hedge for a move higher in the markets. That is unless, of course, some institution out there thinks it can challenge the Fed. That may be the case. We'll have to see what happens in the coming weeks.

Yet anytime we have such an imbalance of put buying on the markets, it is always prudent to prepare for the worst. Given the fact that this rally is starting to look strikingly similar to the April top of the previous melt-up rally (we all know how well that ended), and given the spreading turmoil in Northern Africa, this activity can also be interpreted as speculative put buying ahead of a market swoon. Given how terribly dysfunctional the market has become as of late, either scenario wouldn't surprise me at all.

So How Do We Play This?
The major area of support for the S&P 500 sits at 1270. If we see the S&P 500 close below 1270, then the market is headed lower. That much is clear. This means as long as the S&P 500 remains above 1270, the best position is long or on the sidelines. The biggest current risk to the long side of the trade is a potential black swan event like the flash crash. Given the fact that this market is clearly artificially supported by the Fed, it is always very possible to see these sorts of events take hold over the market.

Yet for those investors who do not fear potential black swans in the market, being long until a break below 1270 on the S&P 500 makes the most sense. A break above 1300 would likely send stocks skyrocketing. If you're on the sidelines and fear the market may soon give way -- as many of my colleagues believe -- then stay on the sidelines and watch for 1270.

Disclosure: I am short QQQQ, but could close that position within the next two or three trading sessions.

Source: Put Buying Skyrockets on the CBOE Today