Option trading & technical indicators suggest neartermed pullback

January 25, 202312 Comments

Options markets, and surrounding trading, volume and premiums, can be very telling of neartermed market moves. In fact, if you read my book Smart Money, Dumb Money, there is a chapter in the book featuring an interview with Jason Goepfert of Sentimentrader. He notes that option indications covering these factors are amongst the most accurate market predictors amongst the contrarian investment tools available. Today, we’ll take a look at what the options markets are telling us about the current rally, followed by a look at my near termed timing system for some technical guidance.

Premiums at 20 year highs on calls

According to BearTraps research:  “Right now – coming out of a bear market, buying equity upside (calls) is the most expensive in 20+ years relative to puts (the cost of buying downside protection) –  maybe all time – coming out of a bear mkt.”

They go on to say:  When you are coming out of a bear market, think Q1 – Q2 and Q3 2009 and 2020, downside protection should be FAR MORE expensive, and the cost upside should be ALOT cheaper.”

CONCLUSION – Bear markets DO NOT usually end with upside call buyers rushing back in  with downside protection this cheap on a relative basis. At the very least, this is a neartermed caution signal. 

 

VIX

The volatility index measures option premiums. It can show levels of fear (opportunity) when its over 35, and complacency (caution) when its under 12. I’ve posted on this blog another pattern that has emerged since 2020. That is, a tendency for the VIX to “dislike” staying much below 20 for too long. As 20 is cracked, we tend to see a reversal of its level, and a selloff on the markets in the very near-term. I’ve marked with purple vertical arrows three of the brief sub-20 moves since the bear market began in 2022. You can see neartermed corrections following that VIX signal. We are once again seeing sub-20. It could get deeper as it did in 2021. But, it has not been doing so since the bear began. Food for thought…

 

PUT/CALL ratio

Here’s the CBOE Put/Call ratio. This shows us the volume of option contracts traded – comparing puts (protection) vs calls (optimism). Deep levels of complacency (too few puts) can be seen with a 0.75 :1 put to call ratio. Deep fear (too many puts) can be seen with a 1.25:1 ratio.

Since the bear of 2022 began, the Put/Call ratio has bounced between around 0.80-0.85 (occasional touches of 0.75) at the “not enough fear” levels. This signals a neartermed sell. At the other end, it has gone into it traditional fear range of 1.25+. This can signal a neartermed, or (when in a cluster) a long termed buy.

The cluster of 1.25 + through 2022 indicates that the bear is growing old and a new bull will emerge soon. Meanwhile, there will be volatility (please, say it ain’t so!). Recently (a few days ago) we saw 0.85. Not a huge sell signal, but certainly a potential for a neartermed correction based on recent market trends.

 

Near termed timing system

Long termed followers of this blog will recall that I like to use what I call my “Near termed timing system” to identify quick movements on the markets. Its actually pretty accurate, with the caveat that its only valuable for predicting very, very short moves. Sometimes these moves last only a few days. In other words, just because we get a signal, doesn’t mean its worthy of a trade.

The system isn’t fancy. Its simply a daily chart with default settings for Bollinger Bands, Stochastics and RSI applied to it. For corrections, I look for a market or stock to be trading at the top of its BB, the stochastics level to be over the “overbought” line, and RSI to exceed 60 (at least). As an aside – RSI overbought is 70, but sometimes the 60 line gives us a signal if the other two indicators are lined up. Obviously, for bounces, the opposite levels on these three indicators should be observed (lower BB touch, lower stochastics oversold level, RSI at or below 40, preferably 30).

The chart below shows us the sell signals on those 3 indicators. Note that RSI hit 59.5 yesterday – which is just barely below the required “60” level. The other two indicators are firmly in correction territory. So – take that for what it is – a weak sell signal.

 

Conclusion

As you know, I preach systematic analysis. That, rather than opinions, prognostications and emotional responses to markets. Sure, as noted in an important blog here, the market is currently not seeing a traditional bear market finale at this point. History suggests there may be a final washout to come. Read that blog for the entire story. Having said that, it is not my job to assume anything, including a final washout. You shouldn’t either. We need to follow an unemotional quantitative system. Take my course – here–  if you do not have such a system. You will be happy you did.

My blog from last week, here, spelled out what I am looking for to buy back into the market with conviction. No emotions, no opinions. For now, certain technical and option trading indicators suggest a neartermed pullback. ValueTrend raised a bit more cash on that signal, but not significantly different from what we have held (we went from about 30% to about 33% cash). We’ll likely go back to 30% if the market sells off a bit in the coming days or so. But the big move back to the market, in our case, will not happen until my base trend following rules noted in last weeks blog are triggered.

Final thought–I am about to do a VT Update newsletter – likely to be released early next week. It will cover some of the sector swaps we have been doing. This newsletter is a modified version of the client update we do – with only the names of specific stocks missing. If you subscribe, you will be privy to this information.

Subscribe here if you don’t already (you will get a subscription to the blog, and to the newsletter).

 

 

12 Comments

  • How much, if any, has the high volume of 0DTE options distorted the VIX ? With all the volatility in the last year, it’s hard to understand the VIX these days at levels under 20.

    Reply
    • For readers info ODTE means zero days to expiry. I am sorry Brian, I don’t know the answer to your question. But given there have always been ODTE options in the VIX, the levels that I use would have always included those contracts and thus the historical track record of the VIX should remain valid as a predictive model.

      Reply
  • Hi Keith,

    SPY has closed above the 200 day moving average for a 5th day now.
    It does feel similar to the end of summer 2020, when the macro and earnings outlook looked weak, yet stocks kept grinding up. Even bond King Gundlach was calling for a move through 2800 to fail hard, but it didn’t. This time though, Powell isn’t printing money, so once again, it seems “different this time”. Yet, 5 days above the 200 ma. This is never an easy game to play 🙂

    Your replies are always appreciated.
    Matt

    Reply
    • Read my blog called “Make sure the light at the end of the tunnel isn’t an oncoming train”. The moving average is just one part of my system to prove a trend change. I need a higher low, higher high AND adherence over the 200 day SMA. So, the TSX has met those criteria. Meanwhile, the SPX has not–it needs to break 4100 and stay there a week before I become convinced of a new bull market. Before you ask, yes–the broad NYSE composite has met the criteria, but the problem is that cap-weighted SPX shows us where “the money” is -the market (SPX) still has more capital in the tech growth sectors vs the “other” stuff – and it has yet to break out. It is close – so worthy of watching for a breakout, and i will react per my system by legging in at that time. But rules is rules! I stay put until I get the signal.

      Reply
  • Hi Keith,
    I find it fascinating that the VIX has fallen below 19 while the war in Ukrainian/Russia appears to be escalating with the new promise of Leopard 2 tanks and Abraham tanks.
    Also, WTI is above $82 this morning. Have people not been noticing that gas prices have been climbing again? The TSX is over 20500, and that market is appearing bullish since it’s broken out. Will the TSX not fall if the US markets fall? What areas of the TSX will keep the TSX in a bullish trend if the US markets fall? I find it hard to grasp that the TSX should be doing so well relative to the US markets given that Canada’s consumer is weaker than the US consumer. Canada is more heavily reliant on exports while we have a global recession. Our mortgage rates are climbing with the climb of interest rates bleeding through to people who are either on variable rates or people who are having to renegotiate their mortgages as their term comes up. On a personal level, I am hearing of young people who got into the housing market who are now in financial trouble.
    Anyway, it just doesn’t really make sense to me that the TSX has broken out. Can you share your perspective?

    Reply
    • Wendy–the bottom line is that real estate is not a big factor on our TSX 300 stock index. Commodities are a big factor (next to the banks, which have been in the dog house, admittedly). As I have been preaching – materials metals and even energy are the places to be — and the TSX is heavier in those sectors vs the SPX which is still stupidly overweight in tech growth stocks

      Reply
  • on the other hand I see some nice neckline breakouts. (Shopify, magna and others) perhaps wego higher for a few more weeks before the markets sells off strongly?

    Reply
    • Quite possible Dave. Remember, any technical indicators, or fundamental factors for that matter, are simply giving us a probability reading. Not an absolute.

      Reply
  • Hi Keith

    Hope you can help me understand something:

    When comparing the 200DMA on the S&P or the TSX:

    Is this only if you’re investing in the index?

    If I’m investing in RY.t for example, wouldn’t I just stick with that chart?

    Why would I worry about what the index is doing if I’m investing in individual securities?

    Thank you.

    Reply
    • Lance–I use macro analysis to tell me how to allocate cash/ equity/ beta. I use individual stock analysis to determine which stocks I hold – within my equity and beta allocations. Both utilize using the 200 day SMA – with the exception that with stock picking I also view the sector, the nearer-termed charts, and the momentum studies.
      Take my Online Course. You will be glad you did. It covers all of these things in an orderly manner.

      Reply

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