Stocks have been rallying around news that the Federal Reserve is buying bonds. By doing so, the Fed is pledging to keep market rates low. It comes at a time when the Federal Funds target rate is at 0% to 0.25% and Federal Reserve officials have also promised to keep this rate low for an "extended period of time." Some market watchers worry that these low rates could feed asset bubbles in other areas of the economy and financial markets. After all, very low rates often motivate speculative activity, as borrowing is cheap and hot money looks for opportunities to earn higher returns in riskier assets. But, while it's easy to talk about bubbles, it's difficult to quantify them. Here are three indicators to watch for signs things are getting a little out of hand.
During times of speculative excess, you often see a surge in activity in the options market. Specifically, there is noticeable uptick in equity call volume. (By equity, we mean stock options only, where the activity is driven more by retail and individual investors rather than institutions). For example, yesterday, as the Dow Jones Industrial Average rallied 220 points, total equity call volume across the options exchanges approached 10 million contracts, which is almost double the typical levels.
Notice from the chart, equity call volume has been extremely heavy this week. This increased activity could be a sign that low interest rates are beginning to feed increasing levels of speculative activity. You can find the day's total options volume free at the Options Clearing Corporation web site, optionsclearing.com. The numbers are updated daily. Or, you can get the information intra-day and end-of-the-day by subscribing to a paid service like our web site, Whatstrading.com.
Rather than looking only at call volume, some market watchers like to track the ratio of puts to calls traded each day. This put-to-call ratio can be applied to a specific stock, a sector or a market. For example, the total put-to-call ratio for trading so far today is .64, as 5.6 million puts and 8.75 million calls have changed hands (5.6/8.75 = .64). So, a rising put-to-call ratio is a sign that put activity is picking up and bearishness is on the rise. A falling p/c ratio indicates that more calls are being traded and investors are getting more bullish.
The second chart shows the equity option put-to-call ratio during the past four months. This is the TOTAL ratio for all stock options that have traded across all the exchanges during the past four months. To smooth it out, I computed a ten-day average. Notice that it's been diving over the past four days. So, not only is call volume increasing, but it has been increasing relative to put volume as well. You can find the total put-to-call ratio updated daily at the aforementioned OCC web site. The Chicago Board Options Exchange also provides put-to-call ratios intraday and end-of-day for trading on the CBOE. We offer intra-day and end-of-day p/c ratios by ticker, sector and market for a fee at WhatsTrading.com.
Some people criticize the put-to-call ratio because it only considers put and call volume and not whether the options are being bought or sold. Well, for all you p/c haters out there, the ISEE Sentiment Index might be a better tool. The
International Securities Exchange
created this indicator to track only put and call purchases. It is computed as the day's call buying divided by put buying X 100. Importantly, ISEE considers only trading activity on the International Securities Exchange, which is one of the largest, but among nine options exchanges that list puts and calls today. The numbers are updated on the ISE website, www.ise.com.
The last chart shows the ISEE indicator for equity put and call activity on the ISE over the past four months. Yesterday, as global equity markets rallied around the Fed's pledge to buy more bonds, ISEE saw a spike to 247 and one of its highest levels in recent months. It indicates that 2.5 calls were bought for every 1 put purchase. So, while the bullish sentiment was obvious in the stock market yesterday, it was clear in the options market as well.
Heavy call volume, falling put-to-call ratios and high readings from the ISEE are signs that things are getting frothy. Investors are turning to riskier assets and speculative activity is on the rise. The trend can continue for a long time, but if a bubble is building, it will obviously have important implications once the ride is over. So, keep an eye on ISEE, put-to-call ratios and overall options volume as gauges for just how risky things have become. Once things get really extreme, prepare for the fallout.
Frederic Ruffy is an experienced trader and provides daily commentary and analysis of the options market. He is co-founder of the web site, WhatsTrading.com. His work has also appeared in Futures Magazine, Technical Analysis of Stocks & Commodities, Stock Futures and Options, and Sentiment.
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