From the November 01, 2008 issue of Futures Magazine • Subscribe!

Options redux: 25 years into the revolution

On March 11, 1983, a revolution in trading began when the Chicago Board Options Exchange introduced the CBOE 100 Index. That first cash settled index, which soon morphed into the famed S&P 100 just months after the onset of the greatest bull market in history, was rapidly followed by an explosion of options trading on other major indexes such as the S&P 500 Index, the MMI (Major Market Index), the Russell 2000, and the Nasdaq 100. As trading expanded, so did proxies. Multiple futures contracts, and eventually the latest index substitutes, the ETF series, were brought to market.

While there had been futures trading on the underlying S&P 500 index for about a year prior to the introduction of the CBOE 100 in early 1983, and even options on equities for nearly 10 years, it was trading on the S&P 100 that opened up a whole new world for traders and small investors. Instead of having to buy a basket of stocks, the average investor could buy or sell “the market.” And in spite of the fears of some that this new vehicle was an even more dangerous form of gambling, index options led to greater liquidity in the stock market.

“We knew there was a lot of pent up demand for an options product,” Joe Levin, vice president of research and product development at the CBOE, noted recently. Levin, director of research at the CBOE on the original OEX index development team, said that the group was “confident the new product would flourish….it blazed the trail for other derivatives.” David Krell, current chairman of the International Securities Exchange, who was also on that same OEX index team and who was responsible for marketing the new product, confirmed that “the new index provided a benchmark of performance so that a more diversified portfolio was possible.”

Despite the proliferation of index options, few specialized technical analysis tools have emerged. A perusal of the 820-page authoritative compilation of known and tested market tools (“The Encyclopedia of Technical Market Indicators, Second Edition,” by Robert W. Colby, McGraw-Hill, 2003) yields only four indicators designed to decipher options trading data.

One of those indicators, the Call/Put Dollar Value Flow Line (CPFL), a dollar-weighted analytical tool first introduced by this author in the July 1986 issue of Futures magazine, has continued to perform successfully since inception, while consistently highlighting potential and significant turning points in the stock market.


While many analysts/traders still use “unweighted” call/put data in such indicators as the Call/Put Ratio to mark reversals in the market, inputting such data into a formula has an inherent flaw that can be corrected by the introduction of volume-weighted data.

Unweighted call/put data treats all options equally. For example, 1,000 contracts bought at 10¢ would have a total purchase price of $10,000 while 1,000 contracts bought at $10 would cost $1,000,000. Clearly, the first purchase was in an outlying contract and probably was bought on a whim while the higher valued option was bought in the money by a serious trader. One could argue that the former option was purchased because the investor “knew” something, but a better argument could be made that the more valuable position was made because the second trader knew even more. Nonetheless, the option with the higher dollar value would be weighted at 10 times the value of the lesser option in the CPFL formula.

All options are not created equal, however, by weighting the price of each option relative to its total activity (see “Calculating and using the CPFL”) it’s possible to give more relevant values to all of the data collected prior to formulaic computations and usage.

1987 CRASH

The CPFL provides historical examples. When the stock market sold sharply lower in October 1987, many market pundits claimed that weakness was signaling the end of the bull market that had begun five years earlier in August 1982. While the damage to market pricing was severe, radical selling encompassed only a few days. Nonetheless, many pundits were predicting another Great Crash similar to the debacle of the late 1920s.

But the CPFL was suggesting otherwise (see “Crash but no burn”). During the crash prices at point “B” dipped slightly lower than prices at “A” in the S&P 100 (the Dow and S&P 500 had similar configurations). But notice what the CPFL was doing. Point “b” of the indicator held substantially above point “a” to suggest that even though external pricing had demonstrated severe weakness, call and put dollar volume data had substantially offset each other. Either call buyers had stepped into the market as prices tumbled or there had been a substantial contraction in put buying. The net result was that the CPFL demonstrated little weakness in the face of an historic decline, bottomed relatively quickly, and then rallied to a new all-time high several months before the broad market made new highs. That bullish bias in CPFL suggested that not only was the so-called “crash” just a retracement in a primary bull market, but also that prices should rally to new highs.


Beginning in February 1994, the stock market entered into a year-long, sideways consolidation. In the ensuing months industrial production contracted and a mini recession developed as a large triangular chart formation developed in the major indexes. Finally in early 1995, prices broke to the upside, and out of the consolidation, and the great bull market resumed its upward course.

During the consolidation the CPFL (see “Big move ahead”) moved mostly in tandem with prices. In July 1994, however, there was a worrisome downside break when the indicator dipped to a slightly lower low at point “b.” But then there was rapid upside movement and the indicator reached a new, all-time high at point “c” in early September 1994 even though the underlying stock indexes did not (C). As index prices sold lower (D) late in the year, the CPFL did not confirm weakness and in the first few weeks of 1995 rallied to new highs (e) to suggest that once again the bull trend was alive and well. Thereafter, several weeks later, index prices also followed suit by rallying to new highs.

As the “New Paradigm” and its coincident mantra of “it’s different this time” reached a crescendo in late 1999 and early 2000 (see “End is near”), and as the major market indexes rallied to new all-time highs in March 2000, the CPFL had been looking jaundiced and less enthusiastic for months. The indicator made a peak in July 1999 (a), another in January 2000 (b), and then the final peak in March 2000 (c) along with index prices, but the last two indicator tops were upside squeakers.

As the market struggled into the September 2000 high (D) on a retracement rally and to levels just below the previous high, the CPFL (d) had experienced a “dead cat” bounce and recovered only marginally from a new short-term low in May before attempting to struggle back to the September levels. Thereafter, once selling began in earnest the CPFL began moving sharply lower after providing a lingering and major warning of impending stock market weakness.

During the late 2002 /early 2003 bottom, the CPFL did not behave spectacularly into the 2002 lows (see “End is near”). It simply created a very practical double bottom formation along with prices before rallying. The only noteworthy divergence occurred when the indicator broke higher (e) several weeks before index prices (E) the week of April 11, 2003. Prices lagged but then broke out to the upside two months later during the week of June 6, 2003.


In the early weeks of 2004, index prices and the CPFL rallied to intermediate highs (F, f on “End is near”). Thereafter, for the better part of the next two years, prices traced out what was probably the “B” wave of a large A-B-C reaction that began after the 2002 low. But as prices evolved slightly higher from early 2004 through mid-2006, the CPFL was eroding lower. Either call buyers were backing away from the market, net, on a dollar volume basis or put buyers were increasing their activity. The end result was that the CPFL was noticeably weaker than the broad market.

Then came the first week of September 2006 when prices broke higher. But the CPFL continued to lack enthusiasm. Not only did the indicator continue to suffer by moving only marginally higher, but weekly statistics topped out in mid-June 2007 (g) at levels markedly below the 2004 indicator highs (f). That disparity proved to be the largest negative divergence in the history of the indicator.

Adding statistical insult to injury, more sensitive CPFL daily data (see “Where to now?” above) had peaked earlier in February 2007 (a). When index prices finally hit a cyclical high on October 11, 2008 the stage was set for a concerted sell-off. Not only did prices decline (from tops at points C, D, E and F), but the CPFL worked lower and remained below the 2002 lows to suggest that market internals were much weaker than external index prices.” The CPFL was last at its lowest level in nearly 11 years, suggesting very bearish implications for the major stock price indexes going forward.

Since OEX index options began trading, fortunes have been made and lost as hundreds of millions of options contracts have flourished and expired. While dark pools and after hours trading may have the potential to distort call/put statistics by detracting from recordable volume just as index options trading made odd-lot trading, short-interest ratios, and specialist statistics all but obsolete, for the foreseeable future the Call/Put Dollar Value Flow Line should continue to be a valuable tool in the trader’s arsenal.

Robert McCurtain is a technical analyst, market timer, and private investor based in New York City. He can be reached at .

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