FRED GOODMAN'S KEY INDICATORS FOR INVESTMENT SUCCESS
Puts, Calls, Volume and Smart Money
Monday, November 11, 2002
Fred Goodman

Putting option trading under a microscope calls out what the pro's are thinking.

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My Smart Put/Call Indicator has been declining again, after apparently bottoming out on July 30th, one week after the market made its low. It has not returned to the depths it reached then, but it hasn't finished declining either.

This indicator is determined by subtracting the 10-day average of the CBOE put/call ratio from the 10-day average of the OEX put/call ratio and calculating the 35-day moving average of the result, which behaves as an oscillator. The theory is that OEX traders are "smart money" and the rest of the option traders are amateurs, at least relative to each other. Very low values for this oscillator indicate that the smart money is more bullish than the amateurs, and that is a sign that the market is bottoming out if the smart money is really smart.

The buy signal occurs when the oscillator first starts to turn up from below 0.3 on the chart below. Clearly, that has not happened again after the first turn up in late July. When it does, we may be in for another ride. I have been looking more deeply into the phenomenon. The circled area below has been dissected, and appears in the chart after the one just below.

Smart Put/Call Indicator
Through Friday, November 8th

The chart below reveals an important relationship between the OEX 10-day put/call ratio and the 10-day average volume traded in puts and calls. The green line represents the 10-day moving average of the put/call ratio. When it is rising, it means that more puts are being traded relative to calls. When it is falling, the opposite is true -- there are relatively more calls being traded than puts. The pink line represents the 10-day moving average of the total volume of puts plus calls. Now it is clear that when the total volume is rising, and the put/call ratio is rising, there must be a huge increase in the number of puts being traded. It is also true that when the volume is rising, but the ratio is falling, there must be a huge increase in the number of calls being traded. Both of these situations appear in the chart below.

OEX Put/Call Ratio and Option Volume
Through Friday, November 8th

First look at the converging green arrows in the center of the chart. This represents a period, just before the July rally kicked in, during which volume was rising and the put/call ratio was falling. If the "smart money" is really smart, this would be an excellent time for us to start buying, and indeed it was. Notice also that the put/call ratio fell to 0.82, a very low value, just as the market bottomed after the period of converging green arrows. This also corresponded to the absolute high volume, which occurred at the very bottom of the market decline.

Now turn your attention to the series of 4 red arrows alongside of the rising put/call ratio (green line), just after the two converging green arrows. The 4 red arrows are paired with the 4 red arrows adjacent to the (pink) volume line. Two of the volume arrows are rising when the put/call ratio arrows are also rising. During those periods there was a big increase in the number of puts traded, signifying that the "smart money" expected the market to decline. It was not long after that the rally stopped and the August/September massacre began.

There are two other relationships possible. Falling volume with rising put/call ratio, and falling volume with falling put/call ratio. In the first situation, when ratio and volume are diverging, it must be interpreted to indicate that there is a decline in the number of calls traded. The volume of puts may be rising, falling or staying the same, but the calls are declining. This situation appeared just after the July rally began, and it is not surprising since we just determined that there had been a huge increase in call buying during the decline into the July bottom. It is logical to think that the call buyers would want to take their profits during the rally. It happened again as the third pair of red arrows indicates. This was just as the advance topped out, during the first part of the decline.

Finally, we come to the present situation in which both volume and the put/call ratio are falling together. I have outlined this with orange arrows. First of all, we just had a volume high that was equal to the volume at the absolute bottom of the summer decline. However, this volume peak happened with a put/call ratio of 1.16, in contrast to the ratio of 0.82 back in July. This signified that there were a heck of a lot of puts traded as the second leg of the rally began on October 10th. This is totally different from the first leg of the rally. The pros were not as convinced that a real rally was coming as they were in July. Since that peak in volume, both volume and the put/call ratio have fallen sharply. The interpretation must be that put trading was slowing, but there wasn't much call trading either.

There is not enough data in the sample I have analyzed to prove the relationship, but my preliminary interpretation is that the pros have reduced their bearishness, but they do not seem convinced that the rally has staying power. Last week, up to Friday, volume turned up while the put/call ratio fell, indicating that traders were buying calls. But on Friday, the ratio turned up with the volume, showing us that put trading is expanding. Keep in mind that these are 10-day averages so the responsiveness is reduced. However, a look at the daily data reveals that put trading expanded on Monday and Friday of last week. It will be important to watch OEX trading very closely over the next two weeks.


Fred Goodman, CFP, is a fee-only Certified Financial Planner based in Los Angeles. You can send him your questions and comments via email at Fred@MarketMonograph.com. The charts and commentary represent what Fred is thinking about the market and thinking of doing for his own account and for accounts he manages. There is no guarantee that you will profit from trading as discussed herein. You may lose money and Fred assumes no responsibility for what you do or do not do with this information.