Sentiment suggests more gains
By Rocky White
Markets have gotten off to a pretty good start here in 2013. Last week, the S&P 500 Index hit its highest daily close since late 2007. It would be easy to say this market is getting a little overbought, but there are a couple of pieces of option data from the International Securities Exchange (ISE) that should keep you optimistic.
ISE Sentiment Index (Equities-Only Version): The first thing that's pretty eye-catching is the ISE Sentiment Index (ISEE), which the ISE reports daily. The ISEE measures only opening long option transactions by its customers -- so this metric excludes option trades initiated by sellers, or by the firms and market makers who are responsible for a lot of hedging and other complex strategies. Using only customers' opening long positions gives the clearest picture of investor sentiment.
The ISE Sentiment Index is a ratio of call options to put options. Call options, of course, increase in value when a stock price rises, while puts gain value when the stock price falls. Therefore, the ISEE is a ratio of bullish bets to bearish bets. Personally, I like to use a version of the ISE Sentiment Index that excludes indexes and exchange-traded funds (ETFs) and focuses on equities only. That's because option volume on indexes and ETFs is often related to hedging activity, which we'll discuss in the next section.
I took the daily equity-only ISE Sentiment Index reading and averaged the figures over the last 50 trading days to smooth out the data. Below is a chart of the 50-day average of the equity-only ISEE along with the SPDR S&P 500 ETF Trust (SPY), an ETF that tracks the SPX. The current reading of 160 means that for every 100 put options bought to open by customers, they've bought 160 call options. As you'll see in the chart below, the ratio has increased significantly since June, but it is historically quite low. In other words, there is plenty of room left for investors to become more bullish. This represents a large amount of sideline cash that could be deployed into the market, which tells me there is a lot of potential for even more gains.
SPY Option Activity: Along with the ISE Sentiment Index, we also get the exchange's open/close data on individual stocks and ETFs. It breaks down option volume by whether it's an opening or closing trade, and whether the volume is generated by a retail customer, market maker, or broker. I mentioned above that the buy-to-open activity on ETFs is driven by a lot of hedging. For example, some investors like to buy put options on the SPY to hedge their long stock portfolios. Therefore, we interpret option activity on ETFs differently than we do that of equities. If a large number of put options are bought on the SPY, we don't consider these bearish bets on the market. Instead, we look at them as bullish bets, because the put purchases are most likely being used to hedge a long stock position.
Below is a chart of the 20-day put/call ratio of buy-to-open volume on SPY options (notice the ISEE is a call/put ratio, but below we're looking at a put/call ratio). The ratio is currently at an extreme low compared to the last few years. In other words, call volume on SPY is high relative to put volume right now.
To find out exactly why this ratio is so depressed, I separated out the volume by puts and calls in the following chart. Call option volume is at a high level compared to the past -- which is notable, because volumes are typically quite low in December and January. However, the ratio is being skewed by the put volume, which is currently very low.
We can't know for sure the reasons for the low put volume, but we can come up with some reasonable guesses. One reason could be some big-money players are out of the market and on the sidelines. Since they're out of the market, there is no reason to hedge by buying put options on the SPY. However, it's possible hedged players are, in fact, in the market, but they're hedging with another instrument -- CBOE Market Volatility Index (VIX) call options, for example. A third possibility is that they're in the market but are now refusing to hedge, because hedging costs them some profits. If this last scenario were the case, it would be interpreted as a sign of complacency and we would consider that to have bearish implications. Any of those guesses are possible, but we do know one thing from looking at the chart above: major sell-offs have not occurred with the put/call ratio on the SPY at such depressed levels.
Next I want to focus on the high number of SPY call options in the chart above. Since this is presumably hedging activity, the higher-than-normal amount of calls suggests investors have a considerable short position in the market. This theory is substantiated by the chart below, which shows total short interest on SPX component stocks.
The amount of short interest increased quite a bit in the second half of last year, and remains at an elevated level. This is yet another bullish sign for the market going forward. If stocks continue to rise and these short sellers start feeling the pressure, a short-squeeze rally could be a tailwind for the market as bears are forced to buy shares to cover their shorts.
More information about the data products offered by the International Securities Exchange (ISE) can be found on their Market Data Products page.
