A Hedging Ratio For These Volatile Times

Looking at hedging ratios can help gauge the options market

Senior Market Strategist
Mar 30, 2020 at 11:54 AM
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In the December 2019 edition of The Option Advisor, published on November 22, 2019, we at Schaeffer’s highlighted option indicators that were flashy warning signs for the broad market.

Inserted below is the concluding paragraph of that article:

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.

While not necessarily “nailing the top” on the exact day in terms of timing the ultimate pinnacle, option volume indicators suggested unabated optimism was not warranted.
We highlighted at that time that the 10-Day OCC equity-only and all-volume option indicators had swung from elevated levels to low levels in short form, and our OCC “hedging ratio” indicator suggested caution. Then came the coronavirus.

As you may expect from price action over the past month, dramatic swings in sentiment have caused these indicators to flip-flop from bearish slanting to bullishly aligned. The equity-only and all-volume ratios are now at all-time extremes (based on our OCC data that goes back to 2009), and the hedging ratio appears to be putting in a basing formation. Hope may not be lost.

The Options Clearing Corporation (OCC) all-exchange, equity-only 10-day option volume put/call ratio is currently 1.18 (on average, over the past ten days, 1.18 puts traded per every Call).

OCC 2014

At the same time, the OCC all-exchange, all-volume 10-day put/call volume ratio has also been skyrocketing. This metric also matched its equity-only counterpart's all-time high two weeks ago.

OCC 2016

Taken together, the sharp, simultaneous pop in these two put/call ratios point to a sudden shift away from calls and toward puts -- and from a sentiment perspective, it signals unending optimism has switched to bleak pessimism.

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 easy to translate.

Using OCC's volume data, I’ve developed a "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 hypothesis 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 options market.

Using a 10-day moving average to smooth out the daily readings, the OCC hedging ratio has clearly plunged. However, the ratio has not set a new low. It’s critical to know that spikes in this OCC hedging ratio have aligned with many market tops in the past, while low hedging ratio readings have usually corresponded with market troughs.

OCC hedging ratio

Based upon these specific option indicators, it appears that sentiment is quite under the weather at the moment. The diagnosis can be seen clearly on the charts; the outlook is extremely uncertain. Unending monetary policy, bipartisan aid packages, and patience will hopefully guide us through. A major positive to remember is that this time we are coming off of an oversold extreme, instead of vice versa. 

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