In my most recent (6/10/10) Trader's Corner article (see the 'Trader's Corner' tab at the top of optioninvestor.com for all past articles by date), part of an ongoing basic series in technical analysis, I wrote about what 'retracements' can contribute to trading decisions. Another very useful technical indicator relates to daily readings of trader sentiment, especially in comparison to price action.

A CURRENT TECHNICAL UPDATE:

My technical update relates quite a bit to the recent moderating trend of bullishness as measured by CBOE daily equities call volume relative to put volume. We haven’t seen the lopsided move into calls that was the case before this recent downside correction dating from the late-May highs. I take this recent moderation as supporting a bullish case for the market to work still higher from here. I'll get into the theory of 'contrary opinion' after this update.

The ratio of call to put volume (for equities only) is seen in the 'CPRATIO' graph at the bottom of my first chart and comprises the way I measure trader 'sentiment'; there are other ways, but comparing option volume numbers is probably the most common method and most accurate in my opinion to help gauge key turning points.

RECENT MARKET SENTIMENT READINGS:

As seen above, a line represents the ratio of CBOE call to put volume on a daily basis for options traded on equities only. The line goes DOWN, when bullish sentiment goes down. When total daily equities call volume gets down to approximately equal that of daily put volume or even to less than put volume, I consider this to be a type of oversold condition.

While the Nasdaq and the S&P today (Thursday) consolidated above their respective 200-day moving averages and with price action that continues to look bullish to me, the CPRATIO line actually declined slightly from yesterday. When playing the long side of the market, my favorite place to be trading wise is be in calls or long stock when my sentiment indicator is NOT indicating any extreme in bullishness and where prices advance without a rise or much of a rise in bullishness as I measure it.

As this is a 'basics' article on sentiment, I'll go into the topic in depth. Chart examples are from my (Essential Technical Analysis) book. Therefore, the charts used for illustration purposes aren't current like my first one above of the (Nasdaq) Composite, but the principles involved are well demonstrated.

SENTIMENTAL JOURNEY: ONE WAY TO MEASURE MARKET "SENTIMENT"

Now I am a sentimental guy, known to shed some tears at sad movies and during other emotional moments. Besides my prediction for hearts and flowers, I was always a student of psychology, especially as it relates to the madness of crowds and all extraordinary popular delusions. You may have seen a book with a similar title, by Charles Mackay, published by Wiley.

SENTIMENT INDICATORS

One of the important factors to pay attention to in the market, especially at what you think may be a bottom or a possible top, is to measure how bullish or bearish traders are. A conventional and standard way to do this in terms of what shorter-term traders are doing, is to look at the daily CBOE volume numbers of total puts traded to calls.

Total daily put volume is most commonly simply divided by total daily call volume. You can see this ratio daily on the CBOE web site (www.cboe.com). Many if not most charting applications that you pay for will graph this number for you; e.g., QCharts, where the call/put symbol is (or was) QC:PUTCALL.

Why would you want to study this fluctuating number? Principally as a key to how bullish or bearish option traders are getting in terms of where they are actually putting their money. Whether they are more involved with call activity and considered generally bullish, or are more involved with puts and which typically reflects more bearish bets. Of course for example, you could be selling puts, which is a mildly bullish stance. I'm not saying all call or put activity strictly reflects simple bullishness or bearishness. However, the total volume numbers work well for our purposes.

Option traders are the best and brightest of traders; maybe also the most mad at times! As option traders go, so goes the traders and as the traders go so tends to go how investors are seeing things. This raises the question then as to why you would want to want to know the degree of bullishness or bearishness at all?

There is nothing much new under the (market) sun. Charles H. Dow in the late 1800's described how the market tends to go from extremes of bullishness to bearishness. Dow observed, and he was not one to lose his head by getting emotional about the market, that at significant market tops most everyone is bullish and caught up in a sort of mania that the manna will flow from the market forever.

Conversely, at bottoms, he noticed that the mass of people, those who knew what a stock was, were quite pessimistic and didn't want to even HEAR about the prospects for stocks. Like the bear in the woods, they had gone to sleep as far as an interest in the market.

Dow therefore began to expect that the CONTRARY was about to happen whenever popular opinion or market 'sentiment' was heavily leaning one way or the other. Hence the concept of contrary opinion was born. Too 'much' bullishness was bearish and too 'much' bearishness was bullish. This idea has an Alice in Wonderland aspect no doubt!

This concept of contrary opinion is not that different from the concept of 'overbought' or 'oversold'. When most or all, potential buyers have bought already, there are few NEW buyers who will come in to support the market upon any appreciable amount of concerted selling. The same is true when everyone is bearish; no one is left so to speak, to continue to press the short side. Most market participants are already short or on the sidelines (not interested) and a small amount of concerted buying will take the market back up, sometimes sharply.

THE PUT/CALL RATIO measured in the conventional way

When you divide put volume (almost always LESS than call volume) by call volume you will be looking at fractional number. 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 around .9, this is considered to be a sign that the market has reached an extreme in bearishness and suggests potential for an upside reversal.

Now this sounds very simple and easy, right? WRONG! The trickiest thing is that this indicator tends to be EARLY in pegging an actual reversal; a classic 'leading indicator'. Buy or sell 'signals' or extremes are regularly 1 to 5 or even 6 trading days ahead of an actual trend reversal. This suggests, at a minimum, that you need to be carefully watching other things in the market that also weigh in the side of suggesting a significant top or bottom.

The other thing that can make the put/call standard way of measuring market extremes less than useful is the effect of index calls and index puts if the TOTAL CBOE or total combined exchange volume figures are used. There is a lot of hedging or arbitrage activities that go on involving INDEX calls and puts.

Bullish sentiment extremes have tended to occur when CBOE daily EQUITIES (only) call volume equals or approaches 1.9/2.0 or more times that of total daily equities put volume. Readings at this level or above suggests that traders are overly optimistic but may be unrealistic concerning the likelihood of a continued strong advance, as most market participants that are interested in buying in the near to intermediate-term, may have already done so. Of course in strong bull markets, scale up buying can go on much longer than selling goes on in a bear market, where stock tends to get dumped all at once or over a relative short period; e.g., a month.

Many years back I found it useful to EXCLUDE the Index option volume numbers and, over the years, this same approach (of just measuring equities options) has become much more common or even the norm. This tends to take out a lot of the influence of hedging activities and gives a more 'pure' reading on how enthusiastic, or not, traders are for stocks. And by dividing only equities call volume BY daily put volume, I get a whole number. Therefore, a LOW number is bullish and a HIGH number is bearish and represents the same kind of scaling as an overbought/oversold indicator like the RSI or stochastics. Just as I have a hard time standing on my head, I have a hard time translating a high ratio (PUT/CALL) as bullish and a low ratio as bearish.

So, watch what word is FIRST. If put/call, this is the standard way you see this indicator. If call/put, this is Leigh Stevens of OptionsInvestor.com talking and you can see my way of looking at this figure frequently by tuning in to my writings. You heard it here first folks. The downside of my approach and it's a hurtle to do it, is to manually input the numbers into a spreadsheet type program that will graph the resulting line.

Bearish sentiment extremes tend to be reached when my call/put indicator gets down toward a 1 to 1 ratio, and bullish sentiment extremes have been reached when my call/put ratio gets to around 2.0 and above; in major bull markets this figure can get up to around 3 and you see this in my first chart above.

Now that all these words and this concept has perhaps gotten you slightly crazy, a picture will help make sense of it all. Study these charts and then I will have a closing word at the bottom.

CALL/PUT chart; the 'conventional' or standard way to look at option volumes. Chart 2:

CALL/PUT ratio that excludes Index call and put volumes. My next chart shows daily call volume divided BY put volume. I keep this as a custom indicator; e.g., as could be done in Excel, or in my case by inputting the daily numbers into my TradeStation application. For example, today's CBOE equities numbers (6/17/2010) were 1,191,990 calls and 817,501 puts. I drop the last 3 digits and divide 1191 by 817 and get 1.4 (or, carried out to 2 places, 1.45 or rounded off, 1.46). Chart 3:

SUMMARY:

A buy or sell 'signal' as noted on Charts 2 and 3 above was defined by eyeballing the extremes and assuming that move into these areas was a signal so to speak. This is somewhat subjective, but such is the nature of technical analysis. A signal was considered to be 'good' or valid, when a market turning point occurred within 1-5 trading days AFTER the extreme reading.

The put/call standard model was premature in ITS buy signals on several occasions on the decline into the September low, probably due to the 'distortion' of Index activity related to hedging. Sell signals were pretty good on the way down. 'Sells' in BOLD on chart 2, were ones where my CALL/put ratio was confirming. Buy signals occurred in both charts for the two differing calculations at the September low. Secondary buys were good for both methods.

Neither method was good at identifying the peak in early-January. But both were good in identifying a secondary sell point later that month. Both methods were good in identifying the upside reversal in late-February. The put/call standard of chart 2 generated a sell signal around mid-March but was 'unconfirmed' by the Stevens CALL/put indicator. That first sell signal was on target as prices where down for the next several months, although my example chart doesn't extend that far in time.

The usefulness of following option volume activity is greatest when it is looked at in CONJUNCTION with other indicators. What those indicators might be will be the subject of my Trader's Corner next week.


GOOD TRADING SUCCESS!