Friday, May 26, 2006

How Pessimistic Are Traders When Markets Fall?

On the heels of my last post, which found that rises were more likely to reverse if they were not accompanied by an expansion of equity call option volume, I decided to look at falling markets and equity put option volume.

Since March, 2003 (N = 811 trading days), we've had 176 days in which SPY has declined by at least -.50%. Normally, such a large one day decline leads to favorable expectations in the near term. One day after SPY declines half a percent or more, the market averages a gain of .17% (109 up, 67 down). That is quite a bit stronger than the average gain for the rest of the sample of .02% (341 up, 294 down).

When SPY has dropped more than half a percent in a single day and equity put option volume declines on the day (N = 47; showing less bearish speculative interest among option participants), the next day averages a whopping gain of .40% (33 up, 14 down). When SPY has dropped by more than a half percent but put option volume increases (N = 129), the next day averages a gain of .09% (76 up, 53 down).

It thus appears that declines are more likely to reverse in the short run if they are not accompanied by expanded bearish activity among equity put option participants. It does seem as though large single day rises and declines should be viewed with special skepticism if speculative interest among option traders does not accompany the moves. I will be following and refining this research on the Weblog.