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Trader's Corner

Trade and trend checklist - Sentiment and Volume (Part 4)

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After studying the chart PATTERN (#1) of what I'm trading, usually Indexes in my case, then, anything noteworthy regarding an OVER-bought/oversold (#2)situation, the last parts of my "POVS" trend and trade checklist are VOLUME (#3) and SENTIMENT (#4), explanations and examples about which I'm going to complete in today's column.

A look at the chart pattern implies studying things like prices being in a proximity to prior lows or highs, an apparent second bottom or top made near the same price (a double top or double bottom), closeness to a trendline; deflection from or piercing/trading through an important trendline, etc.

In my (2/20) Index Trader column I recently discussed the patterns highlighted in the S&P 100 (OEX) chart below which has been updated to reflect the first trading day of this week -

The pattern of key significance to me was the fact of the rally stopping right in the area of the prior top from late-December/early January. It was assumed then, and borne out with subsequent market action, that this pattern looked like a double top in the making. This implied a significant decline to follow.

Another aspect of pattern, besides the possible double top, was the return to the previously broken up trendline and the potential that this would now mark a deflection point or stopper to the rally. It sure enough did!


#2 - OSCILLATOR (Overbought/Oversold)
I also noted in my Index Trader column the tendency for the Dow 30 Industrials (INDU) to make bottoms or tops when a 21-day (i.e., "length" setting = 21) slow stochastic, a type of indicator called an "Oscillator", reached the kind of extremes shown in the chart below -

The only "false" signal so to speak, given by the stochastic model for the period shown, was at the point of the highlighted red down arrow - it was only beginning a sideways consolidation.

The overall record of the 21-day stochastic as highlighting very good entry points for Dow Index (DJX) calls or puts was very good. To pin down even more precise entry points I employ analysis of Pattern, Sentiment and, for bottoms only, a special indication of Volume.


The explanation of Overbought/Oversold concepts in my last Trader's Corner article can be found by clicking here.

My "Volume" indicator is almost solely an attempt to alert to a upcoming market LOW, typically ahead of when there is a market bottom being made. It's not an indicator that can pinpoint tops as well at all, but its helpful in finding bottoms - but hey, this is at least half the trading opportunities that come along! More so in bull market.

Volume is an important ancillary indicator that is second only to price in being important for technical analysis. Of course in fact, all technical works with is price AND volume information - well, in stock index futures, there is some analysis that can be done with "open interest", but this doesn't enter in here.

Stock market volume will often "precede" price. For example, before a market gets to or near a price area that will be perceived as offering value, especially a market that is in transition, there will usually tend to be a contraction of trading activity (volume) to a similar and reoccurring level and this occurrence will tend to precede the most substantial and sustained market rallies.

The most significant volume figure for stocks, for its use as one type of indication for significant or major bottoms, is UP or ADVANCING volume. Total NYSE daily advancing volume is a count of all shares bought on UPTICKS, or at a price higher than the
preceding transaction.

The study of Up Volume trends is an excellent way of uncovering actual buying interest, or the lack of it, as the UpVol activity reflects a willingness to "pay up" for stocks so to speak. To refine the daily figure, I use a 10-day moving average of advancing volume for both the New York Stock Exchange (NYSE) and Nasdaq.

There is a tendency in any given period, of months or years, for there to be a "base" line for how far (what contraction level) a 10-day moving average of Nasdaq or NYSE Up volume will fall to BEFORE there is a market bottom.

I use for the S&P and Dow indices an a 10-day average of NYSE total daily Up Volume ($UVOL) and a 10-day average of Nasdaq Up Volume ($UVOLQ) for the Nasdaq. I then check for when the average pulls back to a "baseline" and then turns UP - the baseline is a 10-day average value associated with key bottoms.

In the chart below, this baseline figure in recent months was when a 10-day moving average of daily NYSE Up Volume dipped to around 530 million shares. This baseline level varies from time - the number itself is not a constant, only the tendency for a contraction to a similar reoccurring area that tends to occur around the time of, ahead of or just ahead of a major or significant low. To be useful as a trading signal this drop to a baseline figure, than an upturn, should happen along with other aspects of technical analysis pointing to the same thing.


The same indicator will help identify Nasdaq final lows by using a 10-day average of daily Nasdaq Up Volume in relation to its "baseline" - i.e., where this index has tended to bottom in recent months. In recent months the Nasdaq Up Volume indicator has not been getting down to many low extremes before rallying, so the indicator has lately been useful in timing major market turning points.

"Sentiment" is generally considered to be any statistical way that attempts to measure how bullish or bearish traders and investors are regarding the future prospects of the market.

A measure of market "sentiment" I use to see if the market is getting overheated or just the reverse is by examining the daily volume of option call volume relative to daily put volume.

However, the "standard" measure is the put/call number. This is a ratio of total put volume to call volume, such as on the CBOE (Chicago Board Options Exchange) alone or all options exchanges together.

Put volume any given day for both (individual) equities AND index options is compared and is (usually) a fractional number - for example, .75, indicating that put volume was 75% of call volume. If the put/call reading was 1.00, put volume equaled call volume that day, which doesn't happen all that often.

Total daily index AND equities options put volume is divided by total daily call volume. You can check this number all over the place, such as on the CBOE web site or in charting programs like Q-Charts; e.g., under symbol "QC:PUTCALL" I believe.

It has been noticed that when put volume gets quite high, such as being equal to call volume, traders are getting pretty bearish - and, trader sentiment may reflect an "oversold" situation, where the market may finally be near a tradable bottom.

In the case of call volume being very high relative to puts, the market may be at or approaching an "overbought" extreme in terms of how traders feel about the market - bullish or bearish, which way are they trading.

The concept of "contrary opinion" was sort of started with Charles Dow in that he held that extremes in bullishness start being the contrary - bearish. As well, extremes in a bearish point of view an early indication that the market may be near a bottom.

Something that can make the put/call standard way of measuring market extremes tricky is the effect of INDEX calls and index puts in the total option volume figures. There is a lot of hedging by money managers and hedge funds that goes on and this can be related more to that (hedging) than simply how individual traders see the market.

I have found it useful to keep up my own way of measuring option volume numbers. I only look at daily EQUITIES option volume numbers. Its been my experience that a more pure measure of bullish or bearish trader sentiment is gotten this way.

This method also makes an indicator that is more like the other overbought/oversold indicators like stochastics and RSI. A LOW number is suggesting a possible "oversold" market and a high reading is indicating an "overbought" market.

So, with this indicator be aware of the ORDER of the words - the indicator I use is a CALL divided by put volume indicator and it takes OUT Index option volume, using only equities volume totals. (This is different than the PUT/call ratio that divides put volume by call volume and INCLUDES the Index options.)

You see this radio plotted below on an OEX chart. I'm able to put a "custom" data item into my TradeStation software - there are other ways of doing it too such as by keeping this ratio on a spreadsheet. I used to plot it my hand even.

My Call Put indicator as of the 2/23 close today is seen below with the S&P 100 (OEX) chart. The Indicator is pretty self-explanatory. Extremes are seen by how I have the level lines constructed - areas where this daily ratio is suggesting an extreme. This is similar to saying a market may be overbought or oversold -

Sometimes this indicator never produces an extreme on the on the downside, especially in a rising trend - the same situation of a rising price trend, it may produce multiple extremes. The most recent market top was however preceded by a sharp spike up in my sentiment indictor. Indicator extremes, when they are working as an advance "signal", will register such extremes within 1 to 5 trading days of the market turning point - in this case, at least an interim top.


One reason that I thought the recent sell off was suggesting the start of what may be more than a shallow correction, is that the sharp down days barely produced a decline in my Call/Put sentiment indication. That is, traders to not appear to get very bearish in the face of it. I think they must, or will, BEFORE there is a final bottom to this correction.

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

Good Trading Success!!

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