The put/call ratio has taken a serious nose dive in the last seven trading days. The 10-day moving average has declined from 0.71 to 0.65 in that period and is now approaching the lower end of its yearly range.

In midday trading Wednesday, the equity-only put-call ratio dropped to 0.42. Obviously, this has negative implications as a contrary sentiment indicator. From a purely market dynamic standpoint, though, the increase in call-buying also suggests that bulls are becoming fully invested. In addition, it suggests that buying power could begin to dry up even as put protection diminishes, leaving stocks vulnerable to an accelerated selloff.

A rally of the magnitude we've seen lately presents a double-edged sword. While it's a bullish breakout, it also leaves the indices trading well above any near-term support. The fact that the

S&P 500

could fall to the major support level around 1140, a 4% decline, and still remain technically positive for the longer term will not make such a decline any less painful.

Many were expecting the market to gain just 5% to 8% for the year. The S&P is currently up some 6.8% in 2004, with all of that gain coming in the last three weeks. That means investors should think about locking in some profits on their biggest winners and reduce risk by replacing stock with calls or buying some cheap put protection as we head into the end of the year.

As I mentioned

Tuesday, open interest configuration for index options, in which there are nearly five times as many in-the-money calls as puts, should give this Friday's expiration a bullish bias. But with the open interest in November declining noticeably over the last two days and evidently undergoing further liquidation today, the bulk of the expiration impact could be occurring today. Open interest in the S&P 500's November 1175 call is down to 21,000 contracts from 34,000 on Monday, and with volume over 14,000 so far today, I expect the strike's open interest to drop another 50% by Thursday.

And it's still worth keeping an eye on the 1200 strike. Its call open interest has actually increased slightly to 37,885, and could be a trigger for buying. In a research note Wednesday morning, James Hosker, vice president of derivative research at Lehman Bros., calculated that as of Tuesday's close at 1175.43, it would have taken 16,315 S&P 500 futures contracts to delta-neutral hedge the current open interest in November options.

The number of futures required to hedge increase as the market rises and expiration nears. For example, at today's level of 1187, it would require some 27,000 contracts. If the S&P hits 1200 tomorrow, it would take 50,000 contracts to hedge the current open interest of the November S&P 500 options.

Here are some individual issues with above-average option open interest still remaining in November:

  • Merrill Lynch (MER) has 19,872 of the $55 calls outstanding, and 9,413 of the $55 puts. The options represent more than 45% average daily volume in Merrill's underlying shares.
  • Texas Instruments (TXN) - Get Report has more than 35,000 of its $25 calls still open. This represents 26% of the underlying shares' average daily trading volume.
  • SBC Communications (SBC) has 21,000 of its $27.50 calls still open, 23% of the average daily volume.
  • Washington Mutual (WM) - Get Report has 6,560 of its $40 puts still open, representing 26% of the underlying stock's average daily volume.

Kmart/Sears Combo

Kmart

(KMRT)

options are active in the wake of the

merger announcement with

Sears

(S) - Get Report

, but not to the degree you might expect.

Basically, there don't seem to be too many arbitrage or speculative possibilities, and most of the activity seems geared toward position adjustment. The largest trade occurred in the March $105 call and put. Each option traded more than 4,500 times in what may have been a conversion against long stock (selling the call and buying the put) to lock in a sale price of roughly $116.50 per share.

Other strikes with volume today at least equal to the prior open interest include the December $120 call, with 1,250 contracts traded thus far, and the December $105 put, which has volume of 1,450 contracts on prior open interest of just 210 contracts.

Likewise, for a stock that's trading higher by more than $10, or 22%, Sears options are relatively quiet with no strike logging volume above the prior open interest level. This probably means most of the activity is understandable closing of positions.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.