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Trader's Corner

Market 'Sentiment'

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I got the following note from one of our Option Investor Subscriber:

"Sorry that your email box was empty. Sooo, I'll give you some topics:
1.) Market Sentiment. What should we be watching to determine short and mid-term trends?
2.) Point and figure charting essentials. Since the Market Wrap uses these and some people (like me) were not trained in their use, maybe you could discuss this.
3.) The Trading Day. How and when to trade.
4.) E-Minis vs ETF/Index Trading. Advantages and disadvantages. Ex QQQQ vs MNX."

Some of these are bigger topics than others and I would need some clarification or more specifics on item 3 as to how and when to trade; this question or topic is perhaps too general. The others not so.

I have written a lot on what I use as my principle 'sentiment' indicator, but can not only look again at that information in this column, but survey what else is out there that is a measure of the bullish or bearish outlook for market participants. On Point and Figure (P&F) charting, I would note that Jeff Bailey is our resident expert on P&F charts and their use. However, I can cover the basics of this form of charting next time. One other note on my most recent Index Trader column, then on to a look at market sentiment surveys.

I write this on the weekend and my 'Index Trader' section with these articles is seen only on the Option Investor web site. The weekend Option Investor Daily (e-mail) newsletter usually has a web LINK to this article (not the case this past Saturday due me not writing my article until Sunday). The online Index Trader section can be bookmarked after clicking here.

TYPO: I noted in my last (8/19) Index Trader that possible next upside S&P 500 (SPX) objectives seemed promising for a retest of the prior high at 1227 or a new high around 1235. The figures were right on the chart at 1327 and 1335, but wrong in the text of course; today's SPX close: 1280.


Charles Dow was the first widely reported market observer of the phenomena that by the time the majority or vast majority of market participants were bullish or bearish on the market, or on a stock, it was often near the end of a move. From Dow's time on, much has been written on market psychology and the tendency for a widely known market outlook or bullish or bearish market 'sentiment, to be wrong.

It was a the people who were in early in price trends that profited the most from going against the prevailing sentiment. The 'theory of contrary opinion' flat out stated that opinion contrary to the majority was valuable and being in the majority was the least likely to line your pockets in the Street of Dreams. The theory of contrary opinion is what market sentiment surveys rely on. Once 7, 8 or 9 out of 10 investors and traders are convinced that the market will continue to go up or down, it may not be AT the end of a move, but it may well be NEAR at hand. The late-90's bull market was a case in point.

I had people chase me down from my perch at Cantor Fitzgerald to denounce my 'traitorous' attitude when I dared to say that the emperor had no clothes. This was when I said that when these market moves go straight up, in a kind of parabolic 'arc', it is near the end and these situations always end the same, with a collapse in prices.

The widely known ways of measuring market sentiment was through the use of market surveys and, in the options era, the ratio of put volume to call volume or the put-call ratio. If daily put or call volume numbers got to be a bigger and bigger percentage of the total option volume, it was suggesting a contrary trend reversal ahead. If investor and trader surveys started reflecting that 80% were bullish on the market outlook in the coming week or month, look out below.

The Investor's Intelligence Survey polls publishers or writers of market letters and does this sampling weekly, with an outlook for the next 1-2 weeks. The results are sent to subscribers and are not weighted.

There is also the AAII (American Association of Individual Investors) survey. Opinion is solicited daily of the membership and has an outlook of 6 months; the results are sent to the AAII membership.

There is a survey called the Van Hedge Fund, which is a monthly survey of hedge fund managers, looking out the next month, with the results sent out to the press.

Another private survey of fund managers, investors and traders called the Stock Market Sentiment Survey of the Group of 100 (G100) has a weighting system and is done daily, with an outlook for the next trading session; results are sent to the respondents only. Some opinions weigh more than others and daily e-mails are sent in form the respondents as to their having a bullish, bearish or neutral outlook for the next trading day.

PROBLEMS with these market surveys include:
1. They're not readily available to all.
2. They are hard to quantify as to how much bullishness is bearish (contrary opinion) and vice versa
3. Less useful to option traders. As an investor I can be warned off from overweighting stocks in my portfolio if over weeks and months I see steadily rising bullishness, but when do I exit calls exactly? A growing bearishness doesn't define or refine the right time for me to get into index calls.

The 'standard' measure is the daily put-call reading or ratio, or the ratio of total put volume to call volume, usually for all options exchanges together. [A measure of market 'sentiment' I use is by examining the daily volume of call volume to daily put volume on the CBOE for equities options only.]

In the put/call ratio, the put volume total on any given day for both (individual) equities AND index options is compared to total call volume and is usually a fractional number; e.g., .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. You can check this number easily, such as on CBOE web site (www.cboe.com) or in charting programs like Q-Charts; the symbol was "QC:PUTCALL" when I was using that application. This wide availability overcomes the problem of the limited availability of the market surveys.

When put volume gets quite high, such as being equal to call volume, traders are getting very bearish. And, traders are 'closest' to the market so to speak, day in and day out. If in the case of a put volume being quite high relative to call volume, the market may be at or approaching an extreme. Too many traders on one side of the market often suggests that the downside, or upside, may be fully exploited and the trend about to reverse.

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. Of course, selling calls should not be considered an outright refection of bullishness, just as selling puts can be a bullish play. Nevertheless, the majority of option traders are betting on market direction, so call volume goes up on rally phases and put volume increases substantially in declining markets.

When put/call ratios have gotten down to the .40 to .45 area, this is seen to mark a bullish extreme and caution is indicated as to the FURTHER prospects for much more of a rise. When put/call ratios have gone to or above about .90, this is considered to be a sign that there is excessive put buying and bearishness, which may signal an upcoming reversal.

The put-call indicator tends to be EARLY and well ahead in 'signaling' a possible trend change. Buy or sell points are often in fact 1 to as many as 5-6 trading days ahead of an actual top or bottom.

A factor that can make the standard put/call measure 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 o that (hedging) than simply how individual traders see the market.

As many of you know, I have found it useful to keep up my own way of measuring option volume numbers. For example, I only look at daily EQUITIES option volume numbers. I tend to get a more pure measure of bullish or bearish trader 'sentiment' this way, when I exclude the INDEX options volume figures.

I also like to divide total call volume by put volume, not the reverse. This way I have an indicator that is like the other overbought/oversold indicators such as Stochastics and RSI. A LOW number is suggesting a possible 'oversold' market and a high reading is suggesting an 'overbought' situation. I also simply my indicator by just using the CBOE daily volume numbers.

I keep my call/put ratio, plotted under the OEX chart below, by being able to put a 'custom' data item into my TradeStation software. There are other ways of doing it also, such as in Excel. I used to plot it my hand even and graph it that way. As with prices, we want to see the TREND with this indicator.

The chart is somewhat self explanatory, with daily extremes in the call/put ratio relative to the lines suggesting what the extremes are, similar to RSI 70/30 lines suggesting overbought or oversold.

In 5 of the 6 instances noted below with the red down arrows or the green up arrows, the call/put extremes in my indicator were 1-5 days ahead of tradable tops or bottoms in the market. One bearish extreme led the next market bottom by 8 trading sessions, well ahead of what occurred after the other extremes in this indicator.

With the 'normal' lag time after extremes, before tops and bottoms in the index follow, you obviously can't rely on something like this alone. Used with the chart pattern, such as when trendlines are pierced and other indicators suggesting overbought or oversold conditions (e.g., RSI), this indicator is quite useful as one trading input.

The key to the readings of this indicator is, and you'll notice, that readings at or above about 2.1-2.2 have tended to mark at least temporary tops and those have occurred within one to a few days. I also do look at a 5-day moving average of the call to put equities option ratio, which is the magenta line, but I rely on single one day numbers at the extremes and don't wait for a moving average confirmation.

We don't often see these extreme readings, but when they do, it's like saying "ready, get set, go" time to be watchful for a trend reversal in the coming day or up to about 5 trading sessions or a week.

Please send any technical and Index-related questions for answer in Trader's Corner articles to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **

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