Put Proliferation
Looking at growth in bear options
By BERNIE SCHAEFFER
The term "put/call ratio" is familiar even to investors who have never traded an
option. Analysts use it to measure sentiment in the options market, which is
viewed as a contrarian market-timing indicator. The theory is that when this
ratio is high it means that pessimism abounds among option speculators, which
often signals a good time to buy. And the optimism and complacency implied
by a low put/call ratio triggers caution for contrarians.
Of course, defining "high" and "low" put/call ratios can be very tricky, as there
are no absolutes -- low ratios can go yet lower and high ratios yet higher. And
a central tenet of Schaeffer's Investment Research's Expectational Analysis
theory is that the power of a contrarian interpretation of sentiment is a function
of market direction. For example, pessimistic sentiment is to be expected in a
bear market and is thus a weak contrarian indicator except at major extremes.
But pessimism when the bull is in full charge can be an extremely powerful
contrarian indicator of further gains, as markets do not top out until optimism
is pervasive.
Most analysts have restricted their use of put/call ratios to aggregate data for
market timing, and our market timing approach uses such data extensively.
But we've also found the put/call ratios of individual stocks to be of great
value in forecasting their future movement. The only modification we make in
moving from aggregate data to individual stock data is to use put and call
open interest figures for stocks instead of volume, in large part to smooth out
the significant day-to-day variability in stock option volume.
Schaeffer's Investment Research has developed an extensive database of
daily individual stock put-and-call open-interest figures since 1989, which
now numbers about 375 stocks. The average put/call ratio over this period
has been about 0.535, which means there has been a shade under 1.9 open
equity calls for every open put. This makes intuitive sense, as we've been in a
bull market over this decade. Plus, the strategy of selling calls against stock --
covered call writing -- has no popular counterpart on the put side.
It is particularly instructive to focus on those stocks whose put/call ratios have
exceeded 1.00; in other words, stocks whose put open interest has been
larger than their call open interest. This is an unusual situation historically,
which has surprisingly grown less unusual in recent years despite the market's
continued upward onslaught. For example, an average of only 7.5% of the
stocks in the database have had open puts exceed open calls at any point in
time over the past decade. But the average is 11.3% so far in 1999, following
readings of 10.2% in 1998 and 7.2% in 1997.
These "high put open interest" stocks
with put/call ratios exceeding 1.00 have
experienced gains of better than double
the average gain for this group of stocks
over five-, 10-, 15-, 20- and 25-day
periods. In direct contrast to the
popular "irrational exuberance"
concerns, some of this year's biggest
momentum names have been sporting
put/call ratios in excess of 1.00 through
much of 1999. Apple Computer's ratio
soared above 1.5 in mid-October with
the shares in the 70 area, and is
currently in excess of 1.4 while the
stock is trading around 90. Gateway's put/call ratio was consistently above
1.00 from late 1998 through the first quarter of 1999 as the stock was
doubling in price. Since September 1999, Gateway shares have doubled once
again, yet the put/call ratio has remained above parity. Qualcomm's share
price has increased 2 1/2-fold since mid-July, when its put/call ratio first
moved above 1.00, where it has remained except for brief periods in
September and October.
To clearly demonstrate that this proliferation of put activity is not confined to
the techs, note that General Electric has had four distinct periods of put/call
ratios above 1.00 this year. The most recent period began in mid-October
and the stock has since climbed from 115 to above 140 at its recent highs.
Accompanying the growth in these "high put" stocks in recent years has been
an increase in the aggregate ratio of open puts to open calls to its current level
of about 0.62. This growth in bearish option activity with each successive new
high in the market constitutes a major building block for the "wall of worry"
that helps assure that a major market top is not at hand.
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