The options volume-volatility indicator developed a year or so ago is speaking again and getting close to reversing a sell signal generated a couple of weeks ago.
For those unfamiliar with this indicator's characteristics, here is an excerpt of its construction methodology posted a few months ago on TW. None of my work is proprietary (it isn't that great) and since there are no holy grails that I've seen yet anywhere, here is the recipe and indicator explanation:
Options Volume-Volatility "Power" Indicator
The indicator is based upon the power equation used widely in physics and electrical engineering: power = current (times) voltage. The analogy between the electrical power indicator and the market, is electrical current equates to volume, and market volatility is analogous to voltage.
The indicator is one I developed, thus there are probably more clever means of deriving the result, but here is my approach:
1) total the daily put and call volume for the index of interest (QQQQ, OEX, SPX) and construct a 50 day simple MA of the call-put volume total.
2) I then calculate the ratio of the daily total volume/50 day MA, and multiply the result by ten so the ratio is greater than one
3) I then average the daily OHLC numbers of the corresponding volatility index, and construct a 50 day SMA of the daily volatility average.
4) As with the volume, I then divide the daily volatility index OHLC average number by the 50 day SMA, multiplying the result by ten.
5) I then multiply the result of (2) by the result of (4) yielding the daily volume-volatility power value.
6) I then "smooth" the result of (5) using a 20% trend, or 9 day exponential MA. The result of this step is what the blue curves represent on the charts.
One can experiment with different MAs, particularly the one from step (6) to increase or decrease sensitivity. I prefer the shorter EMA, but a longer step (6) EMA would likely cut down on the number of questionable signals.
Current Options Power Indicator Status
First is the OEX-VXO options power series. This variant has not rolled over yet, thus a buy signal has yet to be generated, but has achieved levels usually coinciding with short to intermediate term buy signals. There are examples of "double pump" signals as observed in March and April of 2005, where the first spike of the double pump pattern only coincided with a pause in a decline, and the second spike dovetailed with the actual price bottom.
Time will tell if this current signal is the first half of the double pump pattern.
The next options volume-volatility power indicator is the SPX-VIX series. A buy signal has not yet been generated since the indicator has not rolled over, but the SPX-VIX variant is at its highest level since July, 2002, suggesting a fair amount of concern in the SPX options market. As with the OEX-VXO series, the current spike could be the first half of a double pump pattern, but typically extreme levels as exhibited now, do not lead to double pump patterns.
Next is the QQQQ-QQV series power indicator. This variant is not in the zone usually coinciding with price bottoms, and is currently ranked as neutral. I use the "all exchange" Q4 volume available at the Options Clearing Corp (OCC) website, thus the history for this options power series is limited. Nonetheless, the refusal of Q4-QQV power indicator to reach the "buy zone" levels may be a clue a double pump pattern in the prior two power indicator series will be needed before a meaningful price bottom is in.
Despite the rather moderate price decline thus far in the major price averages, the total (index and equity options) CBOE-only 30 day MA call-put ratio is rapidly approaching extreme levels as seen over the past 11 years.
This is a call-put ratio measure, thus high readings reflect complacency and low levels coincide with fear. The CBOE total options 30 day MA call-put ratio is currently at 1.08, which is in the lowest 5% of total daily values over the past 11 years. I typically prefer the equity options numbers for shorter term sentiment analysis, but the 30 day MA indicator for the total options volume call-put ratio does a good job in reflecting longer term extremes in sentiment.
Moving on to the Rydex money flow indicators, the bull-bear fund share ratio of the four largest bull-bear fund pairs (OTC/Arktos, Nova/Ursa, Titan/Tempest, Velocity/Venture) continues to suggest a defensive posture among Rydex fund traders. This indicator is very near levels achieved at the March 2003, August 2004, and April 2005 price lows. Historically, this indicator is at very bullish levels.
Next is a revisit of the three Rydex largest bear fund composite (Ursa, Tempest, Venture) money flows as measured by a 10 day moving sum, then smoothed with a 3 day MA. The bear fund composite is NAV adjusted to filter out asset changes due to price changes.
This indicator broke out of its eight month range last week, and is now at it highest level since August 2004. Hedging strategies or not, the large money flows into these bear funds over the past two weeks would have to be graded as bullish.
Next is the Rydex asset composite of the three large bull funds (Nova, Titan, Velocity) illustrated as a ten day moving sum of net NAV adjusted asset changes. The indicator recently broke the -100 level which often coincides with sentiment extremes by Rydex traders. Of course, the indicator could go lower and/or remain at these levels for a period of time before prices rally, but this behavior suggests the bulls are getting nervous.
The final chart is the percentage of assets invested in the bear funds of what I refer to as the "new" Rydex funds established in early 2004. This indicator represents the percentage of assets invested in the bear funds (Dow, small cap, and mid cap) relative to all assets invested in the Dow, small cap value/growth, mid cap value/growth, and large cap value growth funds. There are a total of ten funds in this newer Rydex fund offering, three inverse or short funds, and seven long funds.
Despite its limited history, this indicator has done a yoeman's job in identifying sentiment extremes within the Rydex fund complex. Although the percentage of "new fund" assets parked in the bear funds has doubled from its lows six weeks ago, the indicator is not yet at levels usually associated with price bottoms over the past 18 months.
This indicator is suggesting more downside price action may be needed in the intermediate term before a solid bottom is in.
On balance, the sentiment indicators covered in this post are suggesting fear is beginning to creep into the marketplace..... what a difference two weeks makes!! Although these sentiment indicators are not unanimously agreeing sufficient fear is in place for a solid price bottom, it is clear the bottom fishing exhibited a couple of weeks ago has abated.
The weekly OCC buy-to-open call-put volume data is not released until Saturday night following options expiration, thus that important data is not available for additional sentiment evaluation as of the time of this posting. The ISEE sentiment index is suggesting the OCC data will also have burned off the bottom fishing tendencies evident two to four weeks ago. If the OCC data exhibits any important sentiment shifts, the charts will be added to this post later this weekend.