This Ratio Says US Stocks Can Go Higher

While US markets climb to new highs, the flipside is volatility expectations are low.

The measure of this expectation, the CBOE Volatility Index [CBOE:VIX], is trading around lows.

The index is constructed using the implied volatilities of a wide range of S&P 500 index options.

Since stocks fall a lot faster than they rise, it can be implied when traders expect low volatility, they expect steady to rising stock prices.

When the VIX is high, it means option traders expect a lot of volatility and the potential for falling stock prices. That’s maybe why the VIX is sometimes referred to as the fear gauge.

The main point to note from all this, is the effect on option pricing. When volatility is at such low levels, the cost of buying call options is greatly reduced.

And the VIX is trading around decade lows. See for yourself…

Source: Optuma
Click to enlarge

It’s telling us that option prices are very low on the broad market index, and that traders are expecting little volatility over the next month.

With the VIX so low, buying a call option, is a cheap way to go leveraged and long on the market.

One reason you’d buy a call, is if you’re expecting the stock to go up.

The long call, or buying call options, is as simple as options trading gets. The primary use of the long call is when your outlook is bullish.

It’s an alternative to directly buying a stock or ETF to gain leverage, when you expect a rise in value.

And buying calls is on the rise. The ratio of puts (bearish bets) versus calls, (bullish bets) has fallen to the lowest level since 2009, see for yourself…

Source: Bloomberg
Click to enlarge

Traders are using call options to get leveraged exposure in the market, while the low VIX also says options are cheap right now.

The chart suggests it’s bullish when the ratio gets to these low levels, except when you are at a market high, as in 2000. As with any chart, you must interpret it in the context of the real estate cycle, a market top was expected around 2000. This is a cycle every share trader simply must know. If you don’t know it, you must go here.

Note the previous put/call ratio lows in 2003, 2009 and 2013, these were times when the market surged strongly higher.

It’s bullish, that’s your take away from the chart.

The short sellers are feeling the heat

There’s a similar indicator pointing to US bullishness. The influx of short sellers that came into the market in the last few years, are starting to feel the pressure. The average short interest in US listed companies sits at 3.6%, the lowest level since January 2014.

The shorts are fleeing and they’re adding to the buying pressure as they cover their shorts. See below…

Source: Bloomberg
Click to enlarge

It begs the question, why would you be short the US market over the last few years, in the first place? Let’s bring up the monthly chart of the S&P 500 stock index, which is a good gauge of the overall health of the US market.

Source: Optuma
Click to enlarge

The S&P 500 and all the other major US indices are trading around all time new highs. The trend in the charts has been up. Those who were shorting the US market over the last few years were swimming against the current. They believed that markets could not go higher and were trying to pick the top. That will do horrible things to your trading account, if you try and trade it. It’s not the way to make fast money.

Even if you are one of the bears who believe the stock market is overvalued, a ripe for a fall, you just have to wait until the market confirms your view.

Should that view be correct, the S&P 500 will break those monthly lows from the prior year. Until that happens you have to bide your time, if you’re one of the bears.

I’m not of the view the market is headed for a crash. On the contrary, though there will be bumps along the way, the next few years promise still higher stock prices. At Cycles, Trends and Forecasts, we’ve been forecasting this for years. If you want to know our secret, why we can be so confident, go here.


Terence Duffy,
Lead Researcher, Cycles, Trends & Forecasts

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Terence Duffy is an analyst and chartist, specialising in researching economic trends and cycles.  His primary focus is housing and land affordability. But you can also depend on him to offer his unique analysis of stock market charts. As Terence will show you, the charts often forecast, well in advance, the good or bad news to come.

Money Morning Australia