A (Small) Scramble For Protection

11/17/08 8:50 AM EST

Good Monday morning...We begin the new week with some selling pressure in the pre-market futures, with the S&P 500 down more than 20 points from its early-morning high.  Most overseas markets were down a couple of percent, and there continues to be a nearly total blanket of negative news flow.

Last week, we saw that negativity take its toll on traders, as there were a couple of days with relatively high put/call ratios, suggesting that they were scurrying for protection.  But when we look at the put/call ratios from the CBOE or ISE, we have to make an educated guess about what traders are actually doing.

Not so with the weekly data regarding small options traders.  There, we know who is doing what.  Up until this week, these guys and gals apparently weren't all that interested in buying protection for their portfolios, or speculating on more downside to come.  They simply weren't buying a lot of put options in relation to their other strategies.

Last week, that changed as they spent 26% of their total option volume buying puts.  That's one of the highest ratios since the data's inception in 2000, surpassed by weeks in July 2002, October 2002 and mid-March 2008.

They're still buying more call options than I'd like to see, though.  Their call volume took up 32% of total volume, which is on the low side historically but well above the 20% - 25% range we saw during the depths of the last bear market.

In total, the contrast between put buying and call buying pushed the R.O.B.O. Put/Call Ratio to 0.83, the 2nd-highest level in the past five years (it hit 0.91 in March of this year).  That's high enough to be considered pretty extreme, but again well off the levels of the last bear market when we saw the ratio go over 1.0 (meaning they were buying more puts than calls).

Speaking of options, this is options expiration week, something that usually brings out all kinds of conspiracy theories about "them" trying to take the market up or down in order to get certain options in or out of the money.  I'm always a little leery of those arguments, especially on a market-wide basis, but there's always a lot of interest in seasonality surrounding these events.

As for November, the week of option expiration has been positive for the S&P 500 tracking fund, SPY, during 11 out of the past 13 years, averaging +1.2%.  Volatility was remarkably tight, averaging a maximum loss during the week of only -1.1% and a maximum gain of only +2.0%.  8 of the 13 weeks showed a maximum loss that was smaller than -1%, and 11 of them showed a maximum gain that was greater than +1%, so there was a definite positive tilt.  We also have the Thanksgiving holiday coming up next week, but any positive seasonality around that break has been confined to the days immediately surrounding it.

Sticking with SPY, there have been 10 times that the fund was down 2% or more on a Friday, then gapped down at least another -0.5% lower the following Monday.  Buying Monday's open and holding through Wednesday's close resulted in 9 of the 10 trades being winners, averaging +2.4%.  The maximum loss during the trades averaged -2.4% compared to maximum gains that averaged +4.1%.  The larger the loss on Friday, the more positive the results going forward.

We have to take these risk/reward stats with a grain of salt, though, since we're currently witnessing a level of volatility last seen 75 years ago.

Bottom line, the conclusion is the same as we left off with last week - Thursday's reversal was a "key reversal day" which may hold some merit, and many factors suggest it is a sign that the worst is probably over (i.e. seasonality, a multitude of historic oversold readings in mid-October, and subsequent signs of explosive buying interest - two 7% rallies within a month of each other, an exceptionally low Arms Index reading and the quick flip in breadth).

The flush below the lows all seems a little bit too perfect, too clean and easy, but objectively the evidence still points higher over the next one to three months.  I stepped back in with a very small purchase right at Friday's close, and will add a little more if we drop this morning, but we need to see 850ish hold on the S&P in order for me to have some confidence that the positives are going to matter.  If we can't maintain this breakout, then we'll be seeing a level of price destruction never before seen in such a compressed time frame, and I'd have no downside target as to when it may stop - so I have no intention of holding long positions in such an environment.