A few week ago, just as the market was set to plumb new YTD lows, we warned that the put/call ratio on the SPY had just hit its lowest level since January 2017.

The reason we found this notable, is that traditionally extreme downside Put/call positions are associated with market corrections (and vice versa), and the November 10th observations certainly was one, with stocks subsequently tumbling to their 2018 lows.

Meanwhile, the put/call ratio has only continued to slide to fresh multi-year lows, sending an even more ominous correction signals.

So in what appears to be the latest attempt by JPM quants Marko Kolanovic and Bram Kaplan, the duo writes that that clients have been asking how the tumbling put/call ratio should be interpreted – whether this is a sign of complacency (suggesting that investors are underhedged and discounting the possibility of a deeper correction), or caution.

Not surprisingly, JPM’s answer is that “it’s the latter, given the P/C ratio plunge is occurring alongside sharp deleveraging by various strategies and can be explained mostly by increased call demand.”

JPM’s take, of course, is somewhat self-serving and comes hot on the heels of Kolanovic’ latest “quadrupling-down” on his bullish take for risk assets, one which has so far failed to materialize and even following today’s latest short squeeze, the S&P remains down on the year.

How does JPM justify its bullish take on this traditionally contrarian indicator? Before he look at their answer, first some quick perspective.

In the chart below, JPMorgan bank shows the S&P 500 put/call ratio over the past 13 years. This chart illustrates how, after an initial jump caused by early hedging activity, the put/call ratio typically plunges during market corrections (circled in red) and was at its lows during the 2008/9 financial crisis (at a time of extreme investor bearishness).

This, according to the JPM quants happens for several reasons:

  1. investors sell much of their cash equities, which reduces put demand (since you don’t need to hedge what you’re not long to begin with);
  2. options become expensive as volatility spikes, leading some investors to short futures rather than buy puts to hedge further
  3. downside;
  4. call demand increases as investors buy calls or call spreads to hedge right tail risk from being underweight or short equities; and
  5. investors monetize some of their hedges (reducing put OI).

The bank then notes that apart from the last item, none of these flows could be seen as investors being ‘complacent.’

So how does JPMorgan twist the plunging put/call ratio as an indicator of rising caution, and not complacency?

Well, according to Kaplan and Kolanovic, it was not the put OI that declined materially recently, “but rather the put/call ratio’s fall can be almost entirely explained by the sharp increase in calls outstanding to 7-year highs.”

For example, we note that put OI has actually increased by ~6% since Oct 9th (the day before the market’s 3.3% 1-day sell-off), but this pales in comparison with a 37% increase in call OI. To JPMorgan, along with investor deleveraging, this suggests “the put/call ratio decline is largely due to increased demand for calls to replace sold cash positions and/or hedge a rebound/right tail, and should not be interpreted as a sign of complacency.”

Alternatively, what JPM is saying is that while a correction warning light may be lit, this is due to investors piling into calls perhaps in yet another mutated form of BTFD, this time on leverage, in hopes of catching the market rebound when it happens next time. Therefore, the flip said of JPM’s argument is that the tumbling P/C ratio this time is actually the clearest example of complacency, as investors are not even hedging but openly doubling down on bullish hopes that a bounce in stocks is imminent.

If that’s not complacency, we wonder how JPM defines the word.

Of course, should this rebound fail to materialize before the calls expire (in many cases worthless) as the market dips anew, the P/C ratio is likely to drop even more as this time it is the put OI that tumbles for all the cautionary reasons listed above, with the next drop in the ratio likely to plumb new post crisis lows.

Ultimately, JPM’s assessment relies on a subjective evaluation of market conditions, stating that “the P/C ratio is now close to its lowest level since we emerged from the 2008/9 financial crisis, which seems at odds with the much stronger  fundamental picture, and thus could be a sign of investor capitulation.

This is the same “stronger” fundamental picture that Kolanovic has been referring to for the past 2 months as the basis for his bullish refrain, yet which has failed to convince the rest of the market. Perhaps it is time for JPMorgan to consider that its fundamental assessment on the “much stronger fundamental picture” has been wrong all along, and that instead of capitulation, the clear attempt to “buy the dip” with leverage is in fact the clearest indicator yet of widespread complacency in that investors refuse to believe that stocks can drop more and is why they are betting – with leverage – on immediate upside, hence the surge in Call open interest…





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