Stocks Climbing Through the Wall of Worry?

Wall of WorryIn last week’s article, Is Light-Volume Trading a Good Thing?, we discussed the current trend in options volume and its potential effect in helping drive the market higher. As promised in that article, we’re going to take a quick look at the CBOE Equity Put/Call Ratio and its potential to identify the market’s near-term direction.

For those unaware of the CBOE Equity Put/Call Ratio as an indicator, here’s a quick education.

By far, the CBOE Equity Put/Call Ratio is the most widely known broad-market sentiment indicator as contrarian investors have used it since the 1990s. On a daily basis, the ratio compares the total volume of all equity call and put options that trade on the Chicago Board Options Exchange (CBOE).

Like most sentiment indicators, the equity p/c ratio typically shows increasing optimism when the market advances and pessimism when the market drops. In other words, there is a high degree of negative correlation between this indicator and market activity, which is why it is used by contrarian investors. While this is one of the oldest contrarian indicators around, it is still incredibly effective for those willing to monitor its daily moves.

Like the Options Clearing Corp. (OCC) data that we discussed last week, the current trend in the CBOE volume data is showing that options traders are becoming more active as total volume is on the rise.  Over the last three months, the average volume for CBOE equity option volume has increased 8%. We like this activity as it indicates trading activity is on the rise, which in turn suggests that investors are warming-up to the current bull-market trend.

While the total volume activity is supportive for the bulls, the CBOE Put/Call Ratio activity is even better. Over the last month, the S&P 500 Index has moved higher by more than 3%. At the same time, the CBOE equity put/call ratio has moved higher as options traders have increased the number of puts trading relative to calls at the CBOE.

CBOE equity put/call ratioClick to Enlarge

The current trend in the ratio is telling those of us watching the indicator that options traders have been growing pessimistic during the latest equity rally, a sign that stocks are climbing the proverbial “Wall of Worry.”

So what’s the bottom line here? The current action in the CBOE Equity Put/Call ratio is very similar to the activity that we saw in early 2011 after the market (S&P 500) had punched through the 1,200 level. Given the current breakout in the market (above the old 2011 highs around 1,370), the potential for the market to move higher up the Wall of Worry is growing as those bearish traders that have been increasing the put/call ratio will eventually turn to buyers of this market. In other words, there’s another round of buyers getting ready to move into the market.

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