Option Investor
Trader's Corner

'Too Much' of a Good Thing: The Theory of Contrary Opinion

HAVING TROUBLE PRINTING?
Printer friendly version

The market has had some real whipsaw days after the 10/13 low, but has been working higher on balance. The price/chart patterns are bullish as seen in the pattern of 'stair-stepping' higher lows and higher relative highs on the way up in the 3-week old advance.

Two of three ways that I most rely on to measure the technical performance of the trend remain bullish: 1.) the unfolding price pattern and 2.) price momentum (i.e., RSI, 'MACD' and Stochastic indicators) models, which are not showing 'overbought' extremes.

Some examples of charts showing these positives follow. After that I'll discuss the topic of the day, which involves the third of my big-3 price/indicator models: that of 'sentiment', which attempts to measure the level of trader bullishness (or bearishness) and involves the 'theory of contrary opinion'.

S&P 500 (SPX) POKES ABOVE IT'S DOWN TRENDLINE
In an uptrend, it's not enough to make an apparent bottom and begin trending higher, and having successively higher lows. A prior rally high must be exceeded to suggest that an uptrend has developed; that the trend has reversed from down to up.

However, another bullish event, before that higher rally high, is to break out above a down trendline. SPX poked above the down trendline that is seen on the daily chart below ...

Moreover, the RSI 'momentum' indicator has not reached an 'overbought' extreme, although it's heading toward it apparently.

SPX above must still get back above resistance implied by the previously broken UP trendline, at the second down red arrow, currently intersecting around 1227 and then above the prior closing (up) swing high at 1228.8; but that's another story.

WHAT ABOUT ME?
What about the most-trader S&P related index option, the S&P 100 (OEX)? OEX is not there yet in terms of bullish upside penetration of its down trendline around 560-561; or the previously broken up trendline ('kiss of death' trendline) at 564. But, so far so good; market trends unfold and moves don't get to their ultimate destination immediately.

OEX is not in overbought territory yet. Not that the market has to get to some extreme and then 'boom' it will reverse lower, etc., but overbought/oversold readings suggest that an index or stock is more VULNERABLE to reversal type news; or, rather I would say, a big run up, or big decline, makes traders more ready to exit and go the other way.

PICTURE PERFECT BULLISH 'ROUNDING BOTTOM'
The hourly OEX has this textbook example of a rounding bottom. Usually, when prices move toward the right side of a rounding formation like the below, there is often an acceleration to the upside.

Continuing with the bullish CHART picture and moving on to the Nasdaq 100 (NDX) daily chart below, today's price action saw a decisive upside penetration of IT'S down trendline. Significant overhead resistance and a minor double top, must be pierced next, but NDX appears headed toward this area next, around 1620.

As with the S&P, the Nasdaq indices, like NDX above, are not yet at any overbought extreme, so no vulnerability to a trend reversal is implied by THIS indicator.

The foregoing daily chart analysis is not to imply that there is not some other ways of measuring more immediate potential overhead technical resistance ...

The emerging hourly uptrend channel suggests that another push higher in the next day or two, will put NDX into possible resistance beginning starting around 1607.

MEASURES OF BULLISH/BEARISH 'SENTIMENT' AS INDICATORS
You will see a regular commentary related to my CBOE Equities Call to Put daily Volume indicator (seen on the OEX chart below) in my Index Trader weekend article; by the way, this article is NOT included in the Sat/Sunday e-mail OI Newsletter, as it's only on the OI Website. There is a LINK to my weekly Index Trader article at the top of the weekend OI Newsletter however; e.g., the (10/29) Index Trader is 'accessible by clicking here'.

My call to put volume indicator is the chief means by which I measure trader 'sentiment' or the degree to which traders are ACTING bullishly or are presumed to have a bullish outlook on the market. When that outlook, as reflected in my sentiment 'indicator', reaches a level or zone where suggests that traders are very to extremely bullish and optimistic for a continued climb in prices, it gets into the top zone; above at least the lower of the topmost dashed level lines in the "CPRATIO" portion of the chart below:

The spikes up in this indicator recently to at or above '2' (call volume is at least TWICE that of total daily equities put volume) is telling me to be especially alert in the next few trading days for a short to intermediate reversal in this current uptrend.

I AM going to attempt to stay with the trend (i.e., stay in my OEX and NDX calls) as long as it continues, BUT will be very alert to a possible reversal; e.g., an apparent rally failure at one of these key trendlines OR at a prior high, etc. I will tend to NOT give the benefit of the doubt to the trend, rather to the possible REVERSAL. Why?

A plot of this ratio between daily all-equities call volume relative to daily put volume tends to become a 'LEADING' indicator. Extremes in this indicator IF also associated at some point with a bearish (chart) PATTERN or an OVERBOUGHT (indicator) extreme, tend to occur a day to as much as a few days (e.g., 3-5) ahead of significant tops. By 'significant' I mean that such reversals are frequently points where its opportune, for example, to exit calls; maybe, as well, to go into puts for a trade.

WHY IS AN EXTREMELY BULLISH OUTLOOK, POSSIBLY BEARISH ?!
Or vice-versa: an extremely bearish outlook could occur not far ahead of a significant bottom. The reality of these things happening could be seen as quite CONTRARY to what we would expect. TRUE grasshopper! This cock-eyed view of the universe deals with a theory of market behavior called the 'Theory of Contrary (Market) Opinion'.

SENTIMENT
'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, the reverse on the downside, is by examining the daily volume of daily equities option call volume relative to daily put volume on the CBOE.

The 'standard' measure of this kind of trader 'sentiment' is called the PUT/call reading. This is a ratio of total put volume to call volume, such as on the CBOE (Chicago Board Options Exchange) alone or on ALL options exchanges in total.

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 think.

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

In the case of call volume being very high relative to puts, trader 'sentiment' may be at or approaching a bullish extreme in terms of how traders feel about the market. Extremes don't last for long, at least in most 'normal' market cycles.

The concept of "contrary opinion" was more or less started with Charles Dow in that he held that extremes in bullishness start suggesting an soon or eventual contrary OUTCOME; e.g., extreme bullishness marks a possible contrary, bearish, situation ahead. As well, extremes in a bearish point of view an early indication that the market may be near a bottom.

Again, why? Because simply that when 'everyone' is bullish, everyone who is going to be in the market is in already. More specifically, most traders that participate in trading/investing has bought the market; e.g., they are long stock, maybe on margin too, long calls, etc. When there is no one left to buy the market, any rough patch like some negative news, will lead to a scramble by some to take profits. This selling is not met by much buying to an absence of new buyers. The old saying is that "bull markets fall of their own 'weight'". This is implying that there are few participants waiting 'under' current price levels to prop it up by buying dips.

The reverse is true at bottoms, where most active traders and investors have sold out and probably lost interest or faith in the upside potential of stocks. Many who are still in the market, are short stock, in puts, etc. A bullish spark can easily set off an initial short-covering rally, which is met by very little selling. Rallies then can go very far, VERY fast.

THE 'PUT/CALL' RATIO, THE CONVENTIONAL WAY
Something that can make the standard put/call method of doing the math and 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. It's been my experience that this is a more 'pure' measure of bullish/bearish trader sentiment.

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.

Summing up, with my use of the indicator be aware of the ORDER of the words the indicator I use divides CALL volume by put volume and only uses equities volume and excludes Index option volume. I call it my CALL/put indicator. Note the difference from the PUT/call ratio in the wording and which divides all option put volume by call volume, INCLUDING the Stock Index option volume numbers.

My indicator, plotted this way, was part of the OEX chart above. I'm able to create a 'custom' data item in TradeStation software there are other ways of doing it too; e.g., keeping this ratio in Excel. I used to plot it by hand even.

My Call/Put indicator as of the (11/2/05) close today was 2.047, or not quite 2.1. This 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 such as currently. Such extremes are similar to saying a market may be 'overbought' or 'oversold'.

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

** Good Trading Success! **
 

Trader's Corner Archives