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.

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