Sunday, December 28, 2008

Option Volumes

Some observations on the implications of the current call option volumes.
Italicized text is from a December 23rd commentary by Richard Band

"... So far in December, the Standard & Poor's 500 index has dropped 3.7%.

Recall that, historically, December boasts one of the strongest records of any month of the year. Such counter-seasonal weakness is an ill omen in itself. "

Not quite, the market has been behaving in a non-historical way. When we say "December is one of the strongest months" we are speaking about statistical results, that the market is up in December 9 out of 10 times (whatever). This statistic says nothing about how much it is up, or anything about the time(s) it wasn't. Suppose we rally 4% Monday, the market will be "up for December", right? but so what?

In the current market is has proved incorrect to rely on past statistical assumptions. Levels which were historically "oversold" were meaningless over the last three or four months.

"The real poison in the cup, though, is the growing complacency with which speculators have greeted this sickly market action. According to my 10-day smoothed CBOE put/call ratio, speculators are betting as heavily on an advance as they did at the top of the abortive rally in May 2008."

If we interpret this information assuming we are in a normal market, then it might be cause for worry.

But, this is not a normal market. We should think about what might be behind the option trades and what they really signify.

Clearly the implication of the remark "To buy calls at an increasing clip in a declining market, however, is financial suicide." is suggesting the call buyers are bullish on the markets.

What other evidence do we have for this? I suggest there is none, that the aggregate perception of market participants is overwhelmingly bearish, not bullish as the call buying would suggest.

If we are willing to agree that market sentiment is, in fact bearish, then how can we explain the heavy call buying?

Trading volumes for the SPX have been running at a rate 450% greater than they were at the 2002-2003 lows. Regardless of the number of splits, new issues or etf's the current volume rates are unprecedented and indicate a substantial increase in selling. I want to suggest that this increase in volume is primarily being caused by short selling.

Short selling increases the float, where once there was one share, now there are two (The original owner and lender of the share, the new owner, who buys from the short seller, so now there are two "long" shares)

We do have evidence that the short interest is at record highs and while the short sellers are sophisticated and trade in the direction of the major trend, they also represent a considerable amount of pent up demand when the markets finally reverse.

I would like to suggest that, based upon the expansions of both trading volumes and the short interest itself, the short-covering demand potentially exceeds the available supply.

As a decline starts to abate, fear driven panic selling contracts and the short side has to decide how to manage their positions. Covering the short by buying the stock back reduces the float, reduces the supply and puts upward pressure on prices.

Covering the short sale also indicates the short seller is willing to close out the position by taking the accumulated profits. In other words, the short seller acts as if the stock has bottomed, whether it has or not.

However, the general market sentiment seems to be still bearish with some participants looking for a temporary rebound before a resumption of the decline. Since the direction of the market always has a degree of uncertainty, a strong rally can cut into the profits of existing short positions.

One way to hedge a short position is by buying calls.

Even as frightful as this decline has been, someone has been buying equities. The increase in volume can only be partially explained by a combination of short selling and short covering. We should assume that institutions with longer term horizons have been buying equities along with the short term traders. Since option premiums are high, covered call writing provides an income flow while the new long holders wait for a price recovery.

However, sophisticated option buyers, market makers etc, will hedge their positions as well, regardless of the direction of the market.

Now, if I am correct and the short sellers are initiating long call positions as a "hedge", along with all the other potential hedging activities which cause short-stock positions to be initiated, then these activities are translated into the market.

What this means is that prices are rising with no appreciable affect on the short interest, that the net effect of a so called "short covering rally" has been to raises prices without substantially reducing the short interest.

The call buying should be interpreted as bullish and that prices will continue to rise.

Wednesday, December 24, 2008


If we assume the deflationary trend abates during 2009, then GOLD has a ways higher to go. The chart is a graphic response to observations by Steven Rock on another message board. It should not be taken as a prediction of the direction for gold over the short term.

Original chart markup was by Steven Rock
Click to enlarge

Monday, December 15, 2008


The McClellan Oscillator has managed to stay above +100 for the past two weeks. Considering the nastiness of the recent decline, this is positive behavior but does not signify the start of an impulse move higher. Rather what we are seeing is a rebound from a crash-oversold position which should last for another two or three months.

The chart below reflects the severity of the recent decline, almost all stocks on the NYSE are in major declines. Over the last three weeks we have begun to see some rebound activity as the Percent of Stocks Above the 50 Day MAVG has started to move up off the floor. Unfortunately the Percent of Stocks Above the 200 Day MAVG has barely budged and is flatlined in the 5% zone.

This is options expiration week and we can expect a choppy market, based on the high MCO reading we could expect a bias to the downside. I still expect the major averages to try to test the 200 day moving averages over the next few months. While I expect the trend to be moderately higher, IRA investors should remain in cash.

SPX with HiLo's and Percent Above
Click to enlarge

Tuesday, December 9, 2008

MCO update for Monday 12-9-08

The McClellan Oscillator is up in rarified territory again and it is unlikely it will go much higher. Over the next day or so we could see a pullback before resuming the upward move in the indexes. I cannot determine whether or not the correction will produce a sharp one day decline of just a day or so of choppy behavior.

The McClellan Oscillator for Monday 12/9/08
Click to expand

The 65 minute DJIA Chart - Fibonacci Time Cycles
Click to expand

Nothing special here, the DJIA continues to work it's way higher against a huge wall of worry. This chart updates the one in the previous posts to provide a check on how well the fibonacci time projections are working. The 610-233-89 nesting missed the low by 3 bars and was the start of the acceleration higher. The 60 is the nominal 10 trading day cycle which looks like it is inverting here or only strong enough to produce a minor correction. It's experimental enough to be fun to just watch but I wouldn't make bets on it.

Updated dialogue at 10:36
Waver said And note how price has broken above the various moving averages. They were resistance, but now the moving averages are support. At least, it reminds me of the charts of late 1929 to April 1, 1930.

Yes, that's what I think as well. It's option time coming up, plus any residual tax loss selling and an high MCO reading, so we could get a little pause here. It is very nice that the markets did not collapse 400 points right out of the chute today. Volatility is high so a 200 point correction is just a nervous jiggle (tell that to my stock george:-) but I'm encouraged here so far.

I really think this is a market one needs to step back, take a deep breath and look at closely to see what is really happening. Is it really the end of the world? Remembering that it always seems like the end of the world at the low, are we really seeing the total collapse of the capitalist system here, or just a major screw up and the pain that goes along with it?

If you look at individual stocks, a lot are down 50% to 80% from their highs of not just a year ago. I'm inclined to think that once again, the market is right and that it is doing what it needs to confuse the most people. The panic we have just experienced is enough to keep the majority waiting for a bottom 30% to 50% lower before they jump in and scoop up the bargains. This seems like a very obvious point of view to hold, how can it possibly be correct?

I think the momentum low has probably been established and that absolute price low may be in as well. If not, I seriously doubt we will make lower lows that are more than 10% lower than what we have just seen. There are some gaps and stuff, along with a need for a positive divergence in market breadth which keep me sanely cautious. But I think the superbears are going to be again proven really wrong.

Tuesday, December 2, 2008

DJIA Fibonacci Cycles

The fibonacci time harmonics for the next few days. There is a nesting occurring this coming Friday, give or take a day.

The DJIA 65 minute chart - 6 bars per day
Click to expand


After five up days in a row. I was probably remiss in not warning that Mondays correction could be severe but why ruin a holiday?

Most of us have never seen such an extreme market decline and there is something which can be learned from the current MCO behavior.

On the chart I've marked some price points P1 and P2 which correspond to the pullbacks which occurred when the MCO corrected from overbought levels above +200 (Points 1 & 2)

Generally speaking, in a 'normal' market a +200 reading on the MCO has bullish connotations. If the MCO moves above +200 WITH the 10% index rising from a corrective low above the -400 level, it is an indication that market breadth is very bullish and that prices are moving strongly higher.

In cases where the 10% Index repeatedly is going below the -500 level, especially in the very rare cases we are seeing now where the 10% Index has gone below -1000 it is clear that the market is very weak. In very week markets the MCO "correction" from the +200 level tends to be VERY SEVERE in terms of price loss and Mondays action proves the case. (Point 4)

In general the severity of the corrections can be inferred from the levels reached by the Summation index. Without sticking hard and fast numbers in the levels, I have generally found that when the SUM Index is "high" market rallies are strong, price movements in individual issues is exaggerated, a larger percentage move occurs. Conversely, when the SUM Index is "low" like it is now, market declines, including overbought corrections like Mondays, tend to be severe, individual issues make exaggerated high volatility moves to the downside. (Point 5)

Point 3 just points out that both the MCO and the 10% Index can stall at/near the zero line. Either this can reverse the trend, or just be a pause to refresh. In the current market, it's probably a good bet to assume the worst and that the markets will attempt to retest the lows again.

However, this nastiness is getting long in the tooth and yesterdays violent move to the downside might have been the bulk of the correction and that we could see an upward reversal sometime in the next few days.

The McClellan Oscillator for Monday 12/1/08
Click to expand

PS: (see chart in the previous post below) Gold decided that deflation was more likely than inflation and acted like a turkey Monday, so much for the 200 day test.