Bulls Face a Bearish Barrier in the Options Market

The following is a reprint of the market commentary from the December 2019 edition of The Option Advisor, published on November 22. For more information, or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- visit our online store.

Not to be outdone by the stock market's run to new records, a number of options indicators have lately been exploring new milestones of their own. After its recent peak above 1.00, the Options Clearing Corporation (OCC) all-exchange, equity-only 10-day option volume put/call ratio has swung to yet another extreme -- this time, on the low end of the spectrum. The ratio checked in at 0.73 on Nov. 15, hitting its lowest point since late September 2018.

At the same time, the OCC all-exchange, all-volume 10-day put/call volume ratio has also been plummeting. This metric matched its equity-only counterpart's aforementioned low with a 0.757 nadir -- and in fact, both of these put/call ratios have since remained below 0.80 for at least 10 consecutive days, an occurrence which last took place in November 2017.

Taken together, the sharp, simultaneous skid lower in these two put/call ratios point to a sudden shift away from puts and toward calls -- and from a sentiment perspective, that's signaling potential giddiness in the options market.

Note that unlike some of the buy-to-open put/call ratios we track internally here at Schaeffer's, these OCC metrics are all-encompassing, in terms of accounting for buying, selling, opening, and closing activity. For example, in some signals, a low ratio might indeed be driven by excessive optimism (high call buying and minimal put buying), while in other instances a low put/call ratio could be driven by bearish activity (call selling – either opening or liquidations). As such, the sheer breadth of the data is impressive, but the sentiment underpinnings aren't always simple to pin down.

That said, the below table summarizes instances since 2009 whereby both the OCC equity-only and all-volume put/call ratios were below 0.80, as they are now. This was a much more common occurrence in 2009 and 2010; there are hundreds of signals in those years, compared to just two or three dozen apiece in 2017 and 2018.

On balance, since 2009, these two OCC put/call ratios have been above 0.80 77% of the time, and they've been below 0.80 only 23% of the time. Looking back over this past decade's worth of data, we find that S&P returns after a low-ratio signal tend to underperform "anytime" returns as far out as a year, albeit by a relatively modest margin. For example, the average two-month S&P return since 2009 is 2.2%, but it falls to 1.8% after a low put/call ratio signal. One year after a signal, the S&P is up 10.8%, on average, compared to its at-any-time 12-month gain of 12.3%.

Using OCC's volume data, Schaeffer's Quantitative Analyst Chris Prybal has developed what he terms the "hedging ratio," derived by taking the daily index/other put/call ratio and dividing that by the equity-only daily put/call ratio. The underlying concept is that there may be a rush to hedge or buy index puts during periods of market turmoil -- and so, by comparing the index activity against the equity-only reading, we can shed some new light on the underlying dynamics of the option market.

Using a 10-day moving average to smooth out the daily readings, the OCC hedging ratio is currently hovering around 1.66, near the high end of its range. Spikes in this ratio have aligned with many market tops when viewing past data, while low hedging ratio readings have tended to correspond with market troughs.

Narrowing our focus to prior instances where this hedging ratio has risen above 1.60, it's been a pretty reliable bearish signal for stocks over the short-to-intermediate term. Since 2012, average S&P returns have been negative as far out as 84 days (roughly four months) after one of these hedging-ratio highs, with the percentage of positive returns consistently arriving below the 50% threshold from one month to four months after a signal. The longer-term returns, while not as bleak, effectively reinforce the implications of our study of the low OCC put/call ratios, which suggested that underperformance may be in store.

As always, we must consider these indicators in the context of the stock market's price action -- and as of this writing, the major equity benchmarks remain within a chip shot of their newly set highs. So while any optimism reflected in this OCC data may well be warranted, and negative S&P returns going forward are not necessarily guaranteed following the latest high reading in the hedging ratio, we'd offer that these data points do represent some potential optimism that needs to be wrung out before the market's next leg higher can begin in earnest.