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Trader's Corner

My 'Sentiment' Indicator

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After my Trader's Corner article last week that discussed the jump in bullishness as indicated or suggested by my CALL/PUT INDICATOR at the end of last week, I received several Subscriber e-mails asking how I constructed it, was it available on any charting application(s) and what has been the history of trader 1-day (or multiple) extremes in bullishness or bearishness predicting trend reversals?

Since we get new Subscribers all the time, OR long-time readers happen to notice something for the first time that I've written on my indicator and/or on the subject of trader 'sentiment' as a contrary indicator, I should go over this again.

As seen in your saved e-mail; or, online by clicking here.

I posed the question in my Wednesday Trader's Corner column of last week (11/15):

This is major. In the nothing new under the sun department, Charles Dow long ago talked about how MAJOR trends don't die/reverse until there are a LOT of 'believers'. The way I measure this is by a 'sentiment' indicator using a simple equities call to put daily trading volume ratio plotted on a graph, as seen in this first chart. Some of the strongest moves come with less than obvious consensus on the outlook for EARNINGS in the coming 6 months to a year.

When there is disbelief or just caution in the staying power of a powerful move, the tendency is for that move to be longer, to go further and with fewer CORRECTIONS than traders especially anticipate. As traders we are used to trading less powerfully trending markets. Non-trending or 'trading range' markets (70% of the time) are more common than strongly trending markets (30% of the time).

If my sentiment indicator doesn't jump to an extreme, it's a good sign for the market trend continuing. This doesnt address the question of how high it can go on the next price swing or ultimately, but it's a good indicator or good indication to stay in the market."

Well, we did see an extreme on a 1-day basis in the call to put volume ratio on the CBOE for all equities options, which hasn't continued this week. Nevertheless, there is a good record of market corrections within 1-5 trading days after any 1-day extreme. That leaves us until Monday of next (11/27), so stay tuned with me!

I'm going to write an explanation on construction, use and rationale in a moment, but first let me go back to the idea of a top or bottom tending to occur within 1-5 days AFTER extremes in this indicator, or levels above 2.1 and below 1.2 as seen on the bottom of the S&P 100 (OEX) chart below. I am going to have to modify this rule of thumb slightly. I am talking mostly about TREND CHANGES. A 'trend change' can be a trend REVERSAL or it can be a notable acceleration of the previous trend:

Example #1: Two days after the early-August dip in the Equities options call to put daily volume ratio, such that daily call volume was nearly EQUAL to daily equities put volume, the market finished it's sideways to lower dip and reached it's lowest low during that time frame; after that low, the market took off in a strong upside extension of the bullish trend.

Example #2: The DAY AFTER the same type call to put reading seen in example 1 in early-October, OEX had a major up day and began another rally of a few weeks before there was even a minor pullback.

Example #3: The way this unfolds remains to be seen; e.g., the start of a (downside) correction, which would be suggested by a daily close below 650; or a reversal/correction after a peak around 660, which I figure may offer some resistance. Stay tuned on that!

To talk about 'sentiment' type indicators involves looking at the concept of 'contrary opinion' in the market.

To understand why extreme levels of bullishness or bearishness tend to lead to a result of an OPPOSITE move ahead in the market, relates to the well-known concept or theory of 'contrary opinion'. This idea really goes back to Charles Dow's observations on market behavior. Dow was always as much a student of investor psychology as anything. He didn't call what he was talking about in this regard as a 'theory' or talk about 'contrary opinion'. Dow simply observed over many years and in different markets that when the mass of investors got extremely sure that stocks were going to keep going up, or keep going down, as 'far as the eye could see', this type of mass conviction was part of what happened near the END of bull, or bear, markets. Why?

The explanation for this is part of what it means to say that a market is 'over'bought or 'over'sold. In the case of a bear market or a bearish (down) swing, most traders or investors who are going to or are prone to sell, have done it already. This dynamic is what 'makes' a bottom so to speak. There are few investors left to sell. Therefore it doesn't take much buying to lift the market.

Of course, for a sustained bull market to begin there has to a change in the conditions relating to companies ability to start to make money or increase their profits. But, usually in a shift from a bear to bull market, individual traders remain bearish or just uninterested in stocks for some time, even if the major indices lift 10, 15 or 20 per cent off their bottoms.

In a bull market it's more common to take time to 'build' a top. The chart pattern tends to be different in bear markets. The final waves of selling tends to be more of a once or twice decision and come more in big surges of selling volume, when traders get really convinced that the market has no hope of advancing. In RISING market trends there is a lot piecemeal buying however. At tops, the mass of investors tend to keep buying, whereas more sophisticated professionals are selling, as they see that stocks have hit PE multiples that are 'over' done; there's that 'over' word again!

In terms of (technical/chart) patterns, this difference in tops versus bottoms explains why there are more 'broadening' or rounding tops, versus more 'spike' lows at bottoms. These two different pattern types tend to be the case whether we're assessing an hourly, daily or weekly chart.
There is a lot more about this subject in my book (Essential Technical Analysis) or in other guides to technical analysis. Mine is no longer being printed by J. Wiley & Sons, although it's still available via Amazon.com, both new and used; although why anyone would sell such a 'gem' is beyond me; but, the (book) 'market' has spoken on this...!

The reasons that market swings tend to be preceded by a build up or jump in bullishness is also part of the nature of mass/mob psychology to go from one extreme to another. What makes 'cycles' in markets is the pendulum like tendency to go from one extreme, then to start to swing back the other way, then all the way. Individuals as part of large groups have a tendency to be unrealistic in their expectations, somewhat less true of market professionals. When you work all the time with something, you know considerably more than average investor for whom market analysis is a part-time or occasional thing.

The point to make relative to my next chart of the S&P 100 (OEX) is that the market really wasn't able to break out to the upside in a new up 'leg', given the overbought-heavily bullish outlook suggested by my call to put readings 1, 2 and 3, where all registered extremes above 2.1 (and, in one instance, example 3, a LOT higher than 2.1).

Within a few days of the peaks seen at 1, 2 and 3 on the lower portion of the OEX chart below, a minor pullback began of 10-15 points in OEX. Ok, back to the Subscriber questions on how I construct this particular indictor.

Very simple, and similar to the common 'Put-Call' Indicator EXCEPT for two key things:

1.) Not SO key to the grand scheme of things, but I like to use whole numbers and read 'oversold' as the BOTTOM extreme and 'overbought' as the TOPmost extreme, just like the RSI and Stochastics and any of the 'overbought/oversold' indicators. To get this result, simply daily Call volume by daily Put Volume (almost always half or less). AND ... there's one other very key aspect:

2.) I use only CBOE daily EQUITIES Volume and take out the STOCK INDEX volumes. (The CBOE is enough of a representative sample that I don't need to use the totals from all options exchanges.) Since there is a lot of hedging activity that goes on in Index options, I get a more accurate reflection of bullishness or bearishness by just looking at the activity in individual equities' calls versus equities' puts.

It's of course also true that there is always some amount of Covered Call writing going on, and selling of puts as a bullish play (or attempt to get put the stock at a cheaper than current price). At times due to some big event in a big stock (e.g., payment of a special dividend), there will be significant related option activity. However, on balance, plotting the ratio of daily CBOE equities call to put volume, results in the most useful 'sentiment' indicator showing the bullish or bearish outlook and the occasional extremes of bullishness or bearishness.

The quirk about using my formula is that you can ONLY chart it yourself; or, write down the daily ratio and track it. You can sign up for an end of the day e-mail that will give you the number as part of the "CBOE Daily Market Summary". Also, a check can be made of the CBOE web site sooner and just after the Close; the final hourly summary will allow a close to exact ratio.

Fellow TradeStation users wrote me and thought that they might have overlooked my "CPRATIO" indicator. Not so, it's just that the TradeStation charting application allows me to create a 'custom' data item by giving this fictitious instrument a name and inputting a closing value each day. The application then charts it like it would any other instrument such as a stock or an index.


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.

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