The Aftermath of Katrina: What's Behind the Market's "Resiliency"?
9/6/2005 12:15 PM ET
By Bernie Schaeffer
I have long held that open interest (rather than volume) is the best tool for analyzing option activity as it is a much more stable series and it reflects what option traders are doing "at the end of the day." Large volume could be indicative of transient day-trading activity (which has no impact on open interest) or could reflect traders closing existing positions (so if there is big put volume on a given day this would be interpreted as reflecting bearish sentiment when in fact it reflects the bearish bets being closed out).
That said, we are in a different options world than we were just a few years ago, as the primary driver of option trades these days is the seller, not the buyer. So if call activity is being driven by those selling calls against stock and put activity is being driven by those selling naked puts - with each of these strategies reflecting a slightly bullish outlook for the underlying asset - what does a "put/call" ratio mean these days?
This almost becomes a question for the philosophers, but in fact there is still a way for practitioners to use the put/call open interest ratios as market indicators, not so much in a sentiment sense as in a structural sense. It is a fact that the open interest put/call ratios for the key indices/exchange-traded funds (ETFs) - S&P Depository Receipts (SPY: sentiment, chart, options) , the Nasdaq-100 Trust (QQQQ: sentiment, chart, options) , the Diamonds Trust (DIA: sentiment, chart, options) , and the S&P 100 Index (OEX - 563.17) - have been high for quite some time. A good example of this is the SPY, on which options began trading this year. The put/call ratio on the SPY has been high pretty much since these options were introduced.
Large put open interest in aggregate almost always means large put open interest at the various strike prices at or below the current price of the underlying asset. Because of the dynamics of options hedging, those on the other side of the put selling trade - who've bought the puts from the sellers - hedge their positions by being long stock. If the market declines, they buy more stock to offset the increased value of their puts. Hence there is a built-in "bid" for the market as it declines, and the more the market declines the bigger the bid. Given the huge put open interest at the 120-strike on SPY, is it any coincidence that it has repeatedly bottomed this week as it approached the 120 level (about 1200 on the S&P)? I think not. (The same could be said for the 38 level on QQQQ, at which there are about half a million open front-month puts.)
Is there a fly in this ointment, or will the "put support" go on indefinitely? Up to now, the put sellers have behaved very confidently and they have not been hedging their positions as the market declines even though they are exposed to substantial losses if the market truly plunges (think October 1987). But if we get to a tipping point that panics the put sellers, their panic will take the form of closing their positions (which causes the other side of their trade to sell the stock they had bought as a hedge) or shorting stock to cover their increased exposure. In either case, this will add fuel to an already declining market, which will panic more put sellers and so on.
The above is why I believe you have to look at this market in probabilistic terms. The high probability situation is what we got this week - the market finds structural support and then continues to grind higher. But the low probability situation is a crash, and this probability, while low in absolute terms, is in my opinion much higher than it's ever been in my history with the market, except perhaps in the summer of 1987.
Needless to say, though, the action this week only further reinforces the thinking that this market is "bullet proof." This is unfortunate, as the best you can say is the market these days - due in large part to the structural support I've just been discussing - is able to absorb a higher caliber bullet than it had been in the past. But the downside to this is that 12-gauge shotgun fire will not only bring this market down, it will devastate it - and all the more due to the complacency that has developed as a result of the non-reactions to events like the London bombing and Hurricane Katrina.
-Bernie Schaeffer |
