Why Is Option Volume Soaring?

It’s coming… Dow 100,000.

The headlines are filled with proof. Day traders are pouring into the markets. Retail investors are flooding brokerages with calls as they set up new accounts. And our old pals at the Federal Reserve are ringing the dinner bell, calling in the masses, as the bank’s tally of funny money has eclipsed the $7 trillion mark.

The effect of all this can be seen in the options market.

I’ve made my living studying trading volume for the better part of two decades.

Price is important… but we know there’s usually a greater fool willing to pay a higher price. What we want to know is how many fools are out there.

Take the housing bust, for example.

Our spreadsheet shows 1.1 million homes sold in 2003… 1.2 million in 2004… 1.3 million in 2005… and, rut roh, back down to 1.2 million in 2006.

In 2007… just 776,000 homes traded hands.

But do you remember when prices peaked?

Volume Doesn’t Lie

The textbooks would have you believe that prices should have reached their highs when sales volume was at its highest in 2005.

It’s supply and demand, right?

That’s hardly ever the case… especially when the Fed is lurking nearby.

It certainly wasn’t this time.

Nope, home values didn’t reach their peak until the first quarter of 2007, nearly two years after volume hit its high.

In other words, tracking the number of folks buying and selling could have saved countless Americans countless dollars… and kept them in their homes.

Too Hot, Already?

As the stock market soars from its March lows, many folks are worried that the market may have gotten too hot, too quickly.

It’s a fair point.

But I caution you to focus not on price… but on volume.

On that front, my Dow 100,000 theory stands firm. Trading volume is surging and showing no signs of letting up.

I like to study option market volume. It gives us a better view of who’s buying what and where they expect prices to head.

Right now, this vital piece of the market is red-hot. In fact, the action last week was the hottest it’s been in 20 years.

In all, traders bought 36.5 million call contracts. That’s 27% higher than the peak in February, when the S&P hit all-time highs.

The action has lots of folks worried about a bubble. But there’s no need to scratch our heads and wonder if things are amiss.

They are. Most certainly.

But this is where it pays to focus on the indicators that matter most.

So Long, Fundamentals

Many investors are wondering whether traditional valuations have gotten too rich. After all, much of the recent run is purely speculative. Stock prices have soared, while earnings expectations have remained flat or fallen.

But with so much free money floating around ($7 trillion worth)… prices are distorted. The appropriate mantra here is easy come, easy go.

As long as the Fed is easing, traditional valuation metrics are mere relics of the good ol’ days.

What does it matter, for example, if a company’s return on equity is falling? The Fed will just loan it some more cheap cash.

It’s why I choose to focus on volume.

The Fed can’t print buy and sell orders… at least not yet. And as far as I know, it’s not buying SPDR S&P 500 call contracts.

Some folks are looking at the “speculative fervor” in the markets as a sign of froth – that trouble is brewing.

They said the same thing in 2009… 2010… and 2011… all the way from one high to the other.

I say investors are right to join the action. There’s easy money to be made.

Until volume wanes… the order is simple. Buy like hell.

Be well,

Andy


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