- 1997: Volume 6, No. 1 Options Traders: Look for the Extreme

Option traders are a volatile group. When the price of the underlying instrument is in a strong uptrend, option traders extrapolate the current trend into the future and become heavy buyers of call options. Conversely, when price is in a sustained downtrend they believe this trend will continue and become heavy buyers of put options.

To the astute market analyst the activity of option traders can provide some useful clues about the technical health of the market. Students of contrary opinion recognize that when an opinion becomes so one-sided, chances are it is fully incorporated into the price structure of the market. To monitor this activity of option traders we keep a daily tally of the ratio of the volume of treasury bond futures put options traded to the volume of call options traded. We then smooth this data from any one day distortions caused by special circumstances by calculating a 10-day moving average.

We have found that historically when the 10-day moving average of the put call ratio increases to above 1.30, it indicates excessive pessimism among option traders and usually coincides with a price low for the bond market. Conversely, when the 10-day moving average declines below .80 it indicates excessive call option buying and usually coincides with a peak in bond prices.

During the average year usually only about two or three extremes in sentiment occur. However during 1996 we saw six extreme readings. Two showing excessive pessimism and four showing excessive optimism. Five of these extreme readings lead to price reversals.

In November 1996, option sentiment became skewed toward excessive optimism as it achieved a multi-year extreme in call buying. Our 10-day moving average of the put call ratio achieved a level of .53 which was the lowest reading in over four years. Additionally, two days featured call option volume at least double that of put option volume.

The extreme bullish sentiment ultimately led to the current price decline from the early December peak. What is interesting is that during this decline option activity still favors call buying. As of January 10, our 10-day moving average of the put-call ratio remains near overbought at .82. Accordingly, we do not expect prices to stabilize and then rally until sentiment as reflected in the put call ratio shifts to a bearish extreme.

Walter J. Burke is a chartered market technician and senior technical analyst with MCM MoneyWatch, a real-time global market analysis firm headquartered in New York. For further information, contact mcm@kisnet.com.