Total Put/Call Ratio Sell Warning Suggests Negative Returns Ahead

For longer term followers of the blog, you may recall my repeated notes on times when the total put/call ratio drop relative to its intermediate range.  The following chart shows the way I have tracked it for years.

Click on Chart to Enlarge

The 5 day average of the total put/call recently dropped to its lower 1 standard deviation band.  This indicates relative complacency compared to the recent range.

Now there is a seasonal tendency to lower put/call reading in December, though they still may be significant.  But today I looked at past instances where the reading came in the doldrums of the year - in this case either July or August.

It is well known that there is a seasonal tendency for increased volatility in the Sept/October time frame, and that many major sell offs historically have often been in Sept and October.  So I wondered if the current signal would reflect a tendency for subsequent market sell offs.

So I looked back through my data going back to 1995 and looked at all similar set-ups on the total put/call in July or August.  I removed any clustered signals after the first in a series so that all readings are "unique".

The short of it is that past signal did indeed lead to average poor performance and negative skews to forward price changes in SPY.

From the 1 month to 5 month forward looking time frames the average MAX loss was greater than 3 times the average MAX gain.

My options trading model shows the following data, suggesting a 200% limit order on an ATM put with 2 months until expiration would be a great option strategy.  And even better according to the past instances (only 9 instances), would be to buy an ATM put option with 2 weeks until expiration and hold until expiration.  In this case that would be basically August standard expiration.  Personally I would rather buy time into September because that is historically the most negative month for stocks.

Click on Table to Enlarge

Some additional data on the equity/ETF side of things.......

At the 1 month forward mark, 7 out of the 9 instances had maximum declines of 2.6% or more.

And at the 4 months forward mark, 8 out of 9 instances had maximum declines of 3% or more.

And using my trading strategy of an OCO limit sell order and stop loss order on an inverse ETF, the MAX return scenario would be to set an 11.25% limit gain per the SPY etf and an 11.25% stop loss.  Then exit at 4 months if neither order is filled.  That would be approximately November 24th.

Now the stats on the past instances justify using leverage of 3x or more on this move, in which case you would take the percentage numbers above for SPY, and then triple them for orders if using an ETF like SPXU to try to capture the anticipated move.

Let me know if there are questions or clarification needed here.  Volatility makes its seasonal lows around this time of year, so understand that it pays to position yourself for the times of year when the odds of a significant move are higher.  It may take a little time to unfold, but feel the indications are clear that downside risk is higher than upside potential here.

Pete