A BUY SIGNAL FOR STOCKS IS EMERGING / BARRON´S MAGAZINE ( RECOMMENDED READING )

The Striking Price

MONDAY, JUNE 14, 2010

A Buy Signal for Stocks Is Emerging

Heavy buying of bearish puts is setting the stage for a market bottom.

By Lawrence McMillan

(Editor's Note: Today's guest columnist is Lawrence McMillan, president of McMillan Analysis Corp, a registered investment advisory in the field of option- and volatility-based strategies.)

PUT-CALL RATIOS ARE excellent contrary sentiment indicators, especially at market extremes. The rationale behind that statement is fairly simple: as a trend in the market perpetuates, option speculators tend to follow the trend.

Assume the market is trending downward. The longer the trend lasts, the more that option speculators buy puts, a bearish bet, as opposed to buying calls, a bullish bet. Near the eventual market bottom, the preponderance of put buying over call buying becomes "too great" (i.e., "everyone" is bearish), and it is a contrary indicator -- denoting a market bottom and a buy signal. Similarly, during extended uptrends, call buying dominates put buying, eventually leading to a market sell signal.

There are various put-call ratios that option traders and technicians look at, but perhaps the most important broad market put-call ratio is the equity-only ratio. The equity-only put-call ratio only considers options traded on stocks – not indices or exchange-traded funds. The standard equity-only put-call ratio is computed daily by dividing the total number of equity puts traded that day by the total number of equity calls traded that day. One usually keeps a moving average (21 days is our choice) to smooth out the fluctuations. That moving average of the put-call ratio trends higher during bearish market phases, but when it rolls over and begins to trend downward, that rollover point (i.e., a peak in the ratio) is a buy signal for the broad stock market. Conversely, the ratio trends lower during bullish market phases, and when it bottoms and begins to rise, that low in the ratio is a sell signal for the broad stock market.

A weighted equity-only put-call ratio is even more useful. In that ratio, one multiples an option's price times its volume, then sums those multiples for all puts, dividing that sum by the sum of those multiples for all calls. Both the equity-only put-call ratios (standard and weighted) gave sell signals in mid-April, for example. Now they are both on the verge of giving buy signals.

However, there is another put-call ratio that usually receives much less attention: the total put-call ratio. In this ratio, all stock and index (but not futures) options are used in computing the put-call ratio. Since this ratio contains "everything but the kitchen sink," it is usually considered to be less useful, especially since index option trading is often dominated by hedging, not speculative, activity. However, there is occasionally a valuable signal that can be gleaned from the total ratio.

It is rare for the total ratio to rise above 1.00, even on a daily basis. In bullish markets, when that happens, it is a short-term buy signal. However, in bearish markets, the total ratio will sometimes rise above 1.00 for several days – indicating an extreme amount of pessimism in the total number of options traded.

We have conducted a study on the total ratio, and a rare, but powerful buy signal occurs when the 21-day moving average of the total put-call ratio peaks at a value above 0.90. Only ten such signals have occurred since 1998. Seven were winners, and three were losers. The successful signals saw the S&P 500 Index (SPX) rise nearly 100 points on each winning signal. The most recent such buy signal occurred in early March of this year, with SPX near 1120. SPX topped out at 1220 a little over a month later.

Not surprisingly, in the recent market drop, put volume has been heavy as bearish fears and forecasts abound. At the current time, the total put-call ratio has tentatively peaked at 1.02 on June 2nd (SPX closed at 1098 that day). If that peak lasts for another few days, it will be a rare confirmed broad market buy signal from the total put-call ratio.

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