How Investor Optimism Could Lead to an Underperforming Market

This indicator will be a cause for concern over the next few months

Senior Quantitative Analyst
Sep 23, 2020 at 8:00 AM
facebook twitter linkedin


Investors are on a call-buying spree right now, creating an extreme reading in the equity-only, buy-to-open (BTO) put/call ratio, which gauges the sentiment of option players. We get option volume from three different exchanges (the CBOE, ISE and PHLX), broken down by whether the options were bought or sold, and whether it was an opening or closing trade. We focus on the volume that is bought to open, because the motivations of the options buyers are clearer. As a refresher, call purchases are a bet that the stock will go higher, while puts are a bet that the stock will go lower (some volume is surely hedging, but we will assume it’s not a significant portion).

The Bearish Implications of Optimism

The chart below demonstrates what is explained above. The all-equity, 20-day BTO put/call ratio has fallen to an extremely low level, suggesting a lot of optimism for stocks. There are two main reasons that optimism among investors often leads to an underperforming market. First, it indicates that many investors are fully bought into the market, so there is less “sideline money” or buying power to push the market higher. Second, with so much money invested, anything that worries investors has the potential to create sharp selloffs as they scramble to exit their positions. 

 SP 20 day BTO

The tables below further support this argument. “I went back to 2014 and found times the 20-day BTO put/call ratio was extremely low, high or somewhere in between. I defined low and high as the lowest and highest 15% of readings since then. Then I summarized the one and three-month returns based on these groupings.” The current reading is extremely low, which tends to lead to an underperforming market. When the reading is low, the index averages a slight loss over the next month. Over the next three months, that becomes more severe, with the index averaging a loss of 1.73% and barely half of the readings positive. In simpler terms, this indicator will be a cause for concern in the weeks ahead.

SP 1 Month 3 Months

Sector View of BTO Put/Call Ratio

The table below breaks down the 20-day BTO put/call ratio of about 40 sectors. Below are the top 20 sectors by BTO volume, or the sectors that have the biggest influence on the overall ratio. The overall ratio is about 0.38, and the top three sectors (technology, retailing and software) have a ratio that is close to this.

The travel/leisure and pharmaceutical/biotech sectors both have low ratios, which indicates optimism. Investors seem to be betting on a bounce-back from the hard-hit travel/leisure industry. Perhaps the thinking is that things will soon open, and that demand will surge back for those services. The bullish bets in pharmaceuticals could be related to hopes of companies creating a treatment for COVID-19.

Finally, there are two sectors where the current reading is above the average. Based on those readings, investors look to be bearish on oil and telecom companies. If you are looking for contrarian stock plays, these are the sectors where investors are most bearish.

Sector 20 Day

 

Minimize Risk While Maximizing Profits

There is no options strategy like this one, which consistently minimizes risk while maintaining maximum profits. Perfect for traders looking for ways to control risk, reduce losses, and increase the likelihood of success when trading calls and puts. The Schaeffer’s team has over 41 years of options trading success targeting +100% gains on every trade. Rest assured your losses are effectively limited to your initial cost at the time of making your move! Don't waste another second... join us right now before the next trade is released! 

 

300x250 - Banner 3 - v1