The Sentiment Indicator That Signals S&P Turning Points

The following is a reprint of the market commentary from the November 2015 edition of The Option Advisor, published on October 22. For more information or to subscribe to The Option Advisor, click here.

As the market continues to recover from its late-August freefall, many are wondering whether stocks are truly on the road to more bull-market highs, or whether we're simply caught up in a bear-market bounce that will ultimately give way to more painful downside. Here at Schaeffer's, one of the unique sentiment indicators we track suggests there's room for cautious optimism right now -- keeping in mind that, with the CBOE Volatility Index (VIX) well off its recent highs, it's certainly an opportune time to avail yourself of portfolio protection in the form of put options.

The 10-day equity-only buy-to-open put/call volume ratio -- compiled by our quantitative analysis team using data from the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX) -- is pretty much exactly as the name describes: This metric reflects the number of puts bought to open, relative to calls, on the three major options exchanges over a roughly two-week trading period.

By narrowing the focus to equity options, we eliminate a fair amount of hedging activity, which often centers around indexes and exchange-traded products -- thereby resulting in a truer sentiment read, where a skew toward puts can be generally considered as "bearish," and a preference for calls "bullish." Likewise, focusing on a 10-day time frame allows us to drill down on very recent option-buying activity, without getting bogged down by the "noise" of single-day data. And with short interest data released on delay every two weeks, we think this is a good indicator of real-time sentiment in terms of measuring how traders are playing the equity market.

In the most basic terms, peaks in this ratio would tend to indicate climactically bearish sentiment among equity option traders, while troughs in the ratio suggest unusually high levels of optimism or complacency. So when this indicator topped out at 0.839 on Sept. 11, and peaked again at 0.818 on Oct. 5 -- its highest levels since the aftermath of the 2008 crash -- we took note of what appeared to be historically significant levels of despair in the options market.

Looking back at post-crisis trends in the 10-day equity-only buy-to-open put/call volume ratio, there's a distinct pattern of peaks in the ratio coinciding with bottoms in the S&P 500 Index (SPX). On March 6, 2009, as the S&P cratered to an intraday worst of 666.79, the ratio topped out at 0.782. And in 2011, the S&P plumbed its low of 1,074.77 on Oct. 4 -- only four trading sessions before the 10-day ratio peaked at 0.731.

A few years later, in August 2014, the S&P hit a short-term low of 1,904.78 on the 7th, which was followed shortly by the 10-day ratio's high of 0.731 on the 13th (exactly matching its October 2011 high-water mark). Of course, as we all recall, the S&P went on to V-bottom at 1,820.66 just a couple of months later, on Oct. 14 -- the same day the put/call ratio topped out at 0.716.

In retrospect, it's easy to say that any of these S&P bottom/10-day ratio peak combos provided solid buying opportunities -- even in August 2014, when you would have faced additional downside in the short term, but very little risk relative to reward over the intermediate-to-longer term. That said, as with any indicator, this 10-day ratio is not "tradable" unless it's confirmed by similar extremes in other sentiment measures, as well as the market's technical performance.

Crucially, it would also be a mistake to trade a peaking put/call ratio. As long as speculators are increasingly negative -- and stacking up their bearish options bets accordingly -- the net effect will be a headwind for stocks that could hamper recovery attempts. Instead, it makes sense to wait for a rollover in the ratio, which would indicate that options players are backing down from climactic levels of pessimism, and pressure on stocks is lifting.

It's encouraging to note, then, that the 10-day ratio has rolled over from its lofty levels of September and early October, having recently set a lower high. And it would be further encouraging for a similar rollover to take place in S&P short interest -- which, like the put/call ratio, has been exploring post-crisis highs. With these supportive sentiment indicators in place, an S&P October close above its 20-month moving average (currently situated just above a key round millennium level at 2,008) would be another point in the bulls' favor as we move into the historically positive end-of-year period.