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November 11, 2005
How Far Will The Put Option Bullies Go To Keep The Bears on Ice?
By Brady Willett

If you had to pick one word that best describes the action in the markets this year it would have to be boring.  For example, the intra-year trading range of the S&P 500 has been only 109 points, and the largest intra-day trading range has been a mere 25.21 points (Oct 19). Back when the bear was roaring in 2002 the S&P 500 traded above a 25 point trading range on 58 different occasions (or 23% of the time) – and that was then the S&P trading below an average of 1,000 versus 1,200 today.

You could argue that the escalation of program trades and the increasing clout of hedge funds has smoothed an otherwise choppy marketplace since 2003. This would be akin to saying that the smart/big money has been shorting volatility (something the LTCM ‘geniuses’ did temporarily).  However, what this theory doesn’t explain is how the ‘smart money’ has been able to suppress volatile market tendencies from emerging during times of uncertainty.  For example, in recent weeks the markets have had to deal with natural disasters, skyrocketing energy prices, Delphi, Refco, hedge fund scandals, GM, Fannie, and a crash in consumer confidence. Beyond a couple down weeks, these challenges have not been so much contended with, but ignored.

Suffice to say, volatility returned to the marketplace in October, but it did not do so in a big way.  Somebody or something wouldn’t allow it.

When Puts No Longer Come To Shove

Ordinarily as the put/call ratio moves higher stocks moved lower and vice versa. This is exactly what took place during the 1996-2000 stock market mania and 2000-2002 bear market. 


As you would suspect as stocks rebounded in 2003 the put/call ratio trended lower. However, this trend proved temporary as over the last 2-years the put/call ratio has started trending higher even as stock prices rallied.  This divergence is not easily explained.


While Occam’s Razor says that the naive herd is buying puts from the smart money, this theory doesn’t explain why the so called ‘smart money’ has suddenly started making one way bets. Astute options players have a history of being equal opportunists – willing to implement premium/beta based options strategies based upon sound analysis regardless of market directionality.  But in 2005 – which is likely to end as the most bearish year ever for the p/c ratio average – these strategies have apparently morphed into one: save the markets during sell offs by aggressively selling put options (
Schaeffers refers to this phenomenon as ‘structural put support’).

Put Writers To Write History

In 1999 at the height of the bull the put/call ratio only closed above 1 on a single occasion. In other words, times were so good in 1999 that market participants only purchased more put options than call options 1 time in 252 sessions. By contrast, at the height of the bear (2002) the put/call ratio closed above 1 a remarkable 22 times (or 8.7% of the time). 

Keeping these numbers in mind, prepare to baffled:

In 2005, with the markets going nowhere, the put/call ratio has already closed at 1 or higher 51-times!

Conclusions

Not surprisingly, Cramer – who for all of his follies has nonetheless been in tune with this year’s boring markets – called the October bottom to the day (after the better than expected Beige Book). Also not surprisingly, the put option bullies did likewise: since October 19 volatility has dissipated, the S&P 500 has rebounded to its pre-October trading levels, and the p/c ratio has moved steadily lower.

Of course, arguing that the put option bullies have found themselves their own private printing press at the expense of bears is speculation. We do not have the required data to ascertain the intentions/plans of the parties playing the 2005 put writing game, nor do we know for sure that put buyers are an unhedged clan of bears praying for a financial market meltdown.  All we do know is that if you have lots of money and you aggressively write enough put options during a downturn, the markets stop dropping.

Just as you have to wonder how far the commercials will go to keep the price of gold from surging, you have to wonder how far the put bullies will go to keep stocks from plunging. However, with the possibility of a serious market decline ebbing in the near term, it may be awhile before any serious wonderment can be had. After averaging 15 and 1.00 respectively in October, yesterday the VIX closed at 11.9 and the p/c ratio settled at 0.78.  Worthless put options in 2005 have given many bears nightmares while exalting somebody or something the status of ‘genius’...at least temporarily.