Equity Options Traders Head For The Hills Again
Due to its unique construction, the International Securities Exchange Equity Call/Put Ratio (ISEE) has become a favorite indicator of ours for highlighting short-term inflection points in investor sentiment. The ISEE excludes firm trades that are quite likely to be hedges and also excludes volume on closing positions when calculating the Call/Put ratio. Therefore, the ISE argues that its ratio is a more pure indication of investor sentiment than some of the other options ratios. If this is indeed the case, we may be near a short-term extreme in “fear”.
The 100 level in the ISEE has historically often been a signal that options traders are becoming fearful (100 means equal call and put volume). Dips below that level have on several occasions come near short to intermediate-term lows in the market as traders have either stormed into puts and/or have shied away from buying call options. The ratio has been below that 100 level for each of the past 2 days.
This is a phenomenon only seen on 6 other occasions in the data’s history since 2006. 5 of the 6 led to very similar behavior by the S&P 500 going forward: very short-term weakness followed by strength in the intermediate-term. Here are the short to intermediate-term S&P 500 returns following these prior occurrences:
Here is a run-down of each of the unique occurrences:
March 17-19, 2008 The S&P 500 formed an intermediate-term low on March 17. It rallied as much as 10% over the next 6 weeks and didn’t close lower for 3 months.
November 17-19, 2008 The S&P 500 dropped over 6% the following day, forming an intermediate-term low. Over the next 6 weeks, it gained as much as 16% above the 19th close and never closed lower over the following 3 months.
June 20-21, 2013 The S&P 500 dropped over 1% the following day, forming an intermediate-term low. Over the following 6 weeks, it gained as much as 8% above the 21st close and has not closed lower since.
October 13-14, 2014 The S&P 500 dropped close to 1% the following day, forming an intermediate-term low. Over the following 6 weeks, it gained as much as 10% above the 14th close and has not closed lower since.
December 11-12, 2014 The S&P 500 dropped 1.5% the following 2 days, forming an short-term low. Over the following 2 weeks, it gained as much as 4.5% above the 12th close and has closed lower just 1 time since.
September 22-23, 2014 This was the exception as the S&P 500 climbed nearly 1% the following day before dropping 6% over the following 3 weeks.
So obviously 5 of the 6 precedents led to very little drawdown, especially in terms of time, and healthy bounces over subsequent weeks.
The September 2014 instance was the exception. One of the differentiating aspects of that occurrence was that the S&P 500 was only 3 days removed from the all-time high. Thus, it seemed odd that there would be a legitimate extreme already formed in the level of fear among options traders. Other than that instance, our current case represents the smallest pullback from the market’s recent high. This is a legitimate reason to at least take pause regarding the current 2-day “extreme fear” reading.
One other possible caveat is that the S&P 500 has been higher each of the past 2 days. Of the 36 historical daily ISEE readings below 100, just 12 have come on “up” days. ISEE readings below 100 are supposed to be an indication of investor fear. It is difficult to believe that the past 2 days have generated fear to any sort of “extreme” level. Perhaps investors have been hedging due to the impending ECB decision, but that is a bit of a stretch. Anyway, the argument is a moot point considering returns following days that ISEE readings below 100 occurred while the S&P 500 was up were in line with (or better than) all such readings:
The conditions surrounding these 2 consecutive ISEE Call/Put readings below 100 have been somewhat unorthodox, given the S&P 500’s proximity to its highs along with its higher closes on each of the 2 days. That said, based on the consistent historical tendency for the market to rally over the subsequent 3-6 weeks following these occurrences, we would consider this development to be a slight positive for the market at this time, albeit perhaps with an asterisk.
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Photo by Keith Alexander.
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