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3 Ratios That Explain the Market Optimism

Small-cap put buying could be hedging

Feb 19, 2021 at 2:30 PM
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For the time being, it looks like the Reddit-fueled mania caused by GameStop (GME) and AMC Entertainment (AMC) has mercifully quieted down. For as useful as it was in drawing the casual observer into the stock market, it's no secret that many involved in the short squeeze battle lost the plot. In what feels a little like a return to normalcy, we're going to discuss some sentiment ratios that could offer a clue into how investors are processing this recent string of broad-market tailwinds.

For the uninitiated; 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.

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. Per the chart below of the 10-day average of equity-only buy-to-open P/C volume ratio with the S&P 500 Index (SPX), you can see it is probing record lows around 0.32. This likely indicates an outright call-buying spree reminiscent of the Reddit-fueled mania from earlier this month.

SPX pc ratio

Now, take that same equity-only 10-day ratio for the tech-heavy Nasdaq-100 Index (NDX) component. That parameter file is showing an increase in put buying, at a relative basis, up to 0.45. But this doesn't necessarily mean investors are suddenly struck with fear. Such ratios are not fear components, even though it’s easy to jump to such conclusions. Instead, that NDX's 10-day ratio coming back to life could more accurately be construed as "hedged put buyers." Investors could be dipping their toe back into tech and hedging their bets with put options, and it's certainly not the call-heavy spread of the all-optionable SPX ratio.

NDX pc ratio

If this is indeed the case, it’s a prudent move even as the NDX logged two record closes in the last five trading days. Profit-taking amid this torrid February run could be right around the corner, as the euphoric sentiment surrounding increased vaccinations and lower Covid-19 cases wears off. But does this tell the whole picture?

Another option-based indicator our research team has been tracking for quite some time now is the 10-day, equity-only put/call volume ratio on only components of the iShares Russell 2000 ETF (IWM). This small-cap exchange-traded fund hit a record high earlier last Wednesday and has been one of the more notable success stories on Wall Street lately. Schaeffer's Senior Quantitative Analyst Chris Prybal notes that the 10-day IWM buy-to-open put/call ratio grazed the 0.50 area before pulling back, but remains in relatively elevated levels from the past year. In fact, it's settled around the late-summer highs of 0.45. In other words, the IWM seemingly has a notable presence of hedged put buyers just like the NDX.

IWM pc ratio

So why are options traders laser-focused on put-buying -- or hedging, as we've surmised -- with the NDX-100 and IWM, but not the surrounding SPX component? Small-cap investors could be trading the news from mainstream headlines, like Bloomberg's recent piece that highlighted the flurry of Russell 2000 stocks conquering their 200-day moving average. Whatever the motive, it should be assuring, to some, to see such a strategy utilized amid the frenzy of logic-defying market activity we've witnessed in the last month.

Subscribers to Bernie Schaeffer's Chart of the Week received this commentary on Sunday, February 14.


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