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Trader's Corner

Market 'Sentiment'

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I received a SUBSCRIBER E-MAIL today commenting that there hadn't been many extremes seen in recent weeks in my 'Sentiment' indicator. The question was if I was seeing any such extremes lately in bullishness or bearishness that would suggest the possibility of the market tacking on further gains or starting to fall again.

My particular way of measuring market 'sentiment' is usually seen depicted on the S&P 100 (OEX) Daily chart that I show in my Index Trader weekend column. As it happens, today I saw an unusual drop in this indicator, suggesting a more bearish or defensive options stance; this, as measured by total equities call and put daily volume numbers on the CBOE. A drop like in line seen below for today is unusual on an up day like today.

Unusual too because the chart still looks bullish in its pattern, showing a sideways drift it's true (after the last sharp up from the up trendline as seen on the chart below), but looking to me like an OEX consolidation ahead of another advance that'll carry above recent highs. The sideways movement, with prices remaining below the possible 'double top' seen on the chart below, may have brought up or brought out more bearish sentiment than seen for a while, as measured by my Indicator seen under the OEX price chart.

By my way of measuring trader 'sentiment' here, there was as much bearishness shown today (by the pick up in equities put volume relative to total daily equities call volume), as seen in several months. A 1-day reading to be sure, but I look ONLY, or primarily, for 1-day extremes. I took today's reading as a positive for maintaining a bullish trading stance and bias.

What we have seen with my 'CPRATIO' Indicator above are many instances where the ratio line got to and above the upper line, suggesting a high degree of bullishness. Very often such spikes in this line were coinciding with, or ahead of, a pullback. On balance, I consider today's sharp drop in my indicator line to be bullish and the opposite of what was being seen by the bearish market outlook suggested by the jump in put activity.

I haven't discussed my version of a market 'sentiment' measure in a while, so will give some background on the topic. For those who have followed this indicator and my explanations for some time already could go read a book or something, especially if it was my own (Essential Technical Analysis)! Kidding of course.

The measure of market 'sentiment' I use as a measure of how bullish or bearish market participants are, stems from examining the daily volume of equities' options put volume relative to daily call volume, with the 'twist' of taking OUT the call and put volume for the index options such as the OEX.

A standard way of looking a sentiment is the daily put/call ratio; e.g., .5, where put volume was half that of call volume. What I use to see if the market is getting 'overheated' so to speak, or the reverse, is to do the ratio a little differently.
1. I use the CBOE figures only
2. Divide total call volume by put volume and not the reverse.
3. Use only the options volume totals for equities alone.

Put volume on any given day for both (individual) equities AND index options is what is normally compared and is most always a fractional number. If the put/call reading was 1.00, put volume EQUALED call volume that day which happens very rarely.

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 (www.cboe.com) or in charting programs like Q-Charts, using I believe the symbol 'QC:PUTCALL'. Correct me if this has changed please!

It has been noticed over many years, that when put volume gets quite high, such as being equal to call volume, traders are getting VERY bearish. The reverse is true when call volume numbers way outstrip put volume; the market is often getting ready for a fall.

Since traders are 'closest' to the market so to speak, day in and day out, people looking for clues to the next big move have taken notice. If in the case of a put volume being high, the market may be at or approaching an 'oversold' extreme in terms of how traders feel about the market bullish or bearish, reflected in which way are they trading.

Obviously how bullish or bearish option traders are is best shown by where they are putting their money - more into calls or into puts and what is the trend of that if you plotted it on a chart, such as seen in the above chart.

Selling calls is not really a bullish play of course, just as selling puts can be a bullish play. Nevertheless, a majority or large plurality of option traders are betting on market direction, so call volume goes up substantially on rally phases and put volume increases substantially in declining markets.

I've often written about how Charles Dow, well over a 100 years ago, observed that at significant market tops most market participants are bullish and at market lows many were shorting stocks, or they were out of the market; no options then!

Dow started writing about the idea that if there is especially heavy buying or heavy selling, the market could be nearing a trend reversal and something contrary to the trend was about to happen when everyone was heavily betting on one direction or the other for the market.

The concept of "contrary opinion" really started with Dow's observations that extremes in bullishness tended to be bearish and bearish extremes in betting on market direction tended to be bullish. This is part of the 'Alice in Wonderland' aspect of the Street of Dreams!

It makes sense when we see that traders and investors mostly REACT to existing trends rather than ANTICIPATE changes in market direction. So, the longer the market goes up or stays up, such as been the case in the past several months now, the more that the 'extremes' are seen in my indicator on the UPside as seen below in the same chart again of the S&P 100.

I wanted to have an indicator that 'reads' like other overbought/oversold indicators such as Stochastics and RSI. Where a LOW number is suggesting a possible 'oversold' condition and subject to an upside reversal; and a HIGH reading is indicating that the market may be 'overbought' and subject to a downside reversal. To do this and get a whole number that goes higher as call volume gets heavier, was simply a matter of reversing what is divided; i.e., calls divided by puts.

Comparison of options volumes, whichever way it's kept, tends to be EARLY, but 1 to a few trading days, in terms of 'signaling' a trend change. Buy or sell points are often one to as many as 1 to as many as 5-6 trading days ahead of an actual top or bottom.

The other thing 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 and hedge fund managers that goes on that distorts the standard put to call ratios that use a total daily volume number that includes both Index and individual stock options volumes.

To get a purer 'sentiment' read so to speak, I've found it useful to only use a daily equities option volume numbers. It takes me keeping a ratio done on a calculator and then putting the number manually into a spread sheet to plot the resulting ratio. With my particular charting software (TradeStation) I can chart a 'custom' data item and what you see in the OEX indicator shown above.

You could also keep this ratio in a log sheet or table, without charting it and just notice when the calls to puts daily equities volume ratio on the CBOE gets to be 2.1 or higher and when the ratio gets to be 1.2 or lower; both suggesting extremes in market sentiment along with trends that may be subject to at least short-term reversals.

Such extreme 1-day readings (or the 5-day average) doesn't often get to these extremes, but when they do and especially if other patterns and indicator extremes are lining up the same way, a high or low call to put ratio is like saying "ready, get set, go" and time to be watchful for a trend reversal or acceleration in an existing trend in the coming day or days; up to 3-5 trading days
days down the road.

Please send any technical and Index-related questions for answer in Trader's Corner articles to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

This Wednesday Trader's Corner article also serves as an adjunct to my weekend 'Index Trader' column. In the article you're reading here I typically often do a brief midweek update of my in-depth weekend column.

You will normally see a web LINK to the Index Trader at the top of your weekend (Sat./Sun.) Option Investor Daily e-mail. This article can be accessed by going to the OptionInvestor.com web site; click on the Index Trader section at top. My most recent Index Trader is also seen by clicking here.

** Good Trading Success! **

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