MAILBAG QUESTION:

..."and what seems a large percentage of investment advisors are bullish, like 60% recently versus 39% bearish, which includes those looking for correction. you look at bullish-bearish outlook by put-call? how do you judge when there are so many bullish or so many bearish that you want to go the opposite way?"

MY RESPONSE:

Good question, so I'll tear myself away from my NFL game where my team is losing big time and write about it on a late-Sunday.

I try to use something that's appropriate for shorter-term trading, which is looking at a 2-3 week to 2-3 month forecasting horizon. Percentage of investment advisors are generally or mostly looking at the 1-2 year outlook in terms of their opinion on holding stocks OR it might be the percentage they advise holding in equities versus bonds, cash, etc.

So, yes, I use daily volume figures for equities options in terms of call volume versus daily put volume. I exclude index options to measure market sentiment as there's too much volume there involved in hedging activities and NOT related as much to individual traders making bets on market direction for their favorite stocks. Instead I want to look at bets on stocks going up (calls) or going down (puts). Of course it's a bit of a crude instrument in that we don't see what percent of call volume is writing covered calls or conversely, selling puts as a bullish play.

Still, these daily volume figures give a pretty good idea when there's a sizable jump in bullishness; e.g., CBOE call volume jumps to 1.5 million (from an average of a million) versus 800,000 puts traded.

Here's another thing with my use of the volume ratio that day: I divide call volume BY daily put volume in order to get a whole number versus a fraction the other way. I do this because plotting this daily volume ratio then registers highs and lows in the same WAY as OTHER overbought-oversold indicators; e.g., the RSI indicator. A low (oversold) reading in a 13 or 21-day Relative Strength Index (RSI), also a ratio, is at 30 or under. A high reading (overbought) in the RSI is 70 or above.

If my call TO put daily ratio is 1, (call volume equal to puts) that's also a LOW number and represents what I call a different 'type' of oversold condition as volume that day is unusually weighted to puts. If a CBOE call TO put volume ratio hits 2, (call volume is twice put volume), that's a pretty bullish condition as traders are going heavily toward calls that day.

This foregoing explanation just simply helps me visually see where 2 indicators line up in the same way; showing an overbought or oversold condition. A line up on my S&P chart would be price action at top and if I see a reversal type chart pattern (e.g., a retreat from a double top) AND a very high RSI reading at 75 AND a lop sided call to put ratio at 2.1-2.3 say, that's gives me a good read on a potential downside reversal.

I'll show some examples next, but the OTHER important rule of thumb is to expect LOW readings on RSI and Call-Put to be far BETTER for a bottom 'signal'. In bull markets call-put readings stay at and above 1.8-1.9-2.0 for prolonged periods or just frequently and that doesn't mean this suggests an impending TOP.

So, a rule of thumb is bottoming price action + low RSI + low call-put figure points toward an upside price reversal and a bullish trading bias. This compares to (downside) price reversal action at an apparent top + an overbought RSI may not be joined by a relatively LOW call-put ratio line like 1.2-1.1-1, in that range.

One more thing is that the Call-Put ratio is a LEADING indicator in that a daily or 5-day moving average that's unusually low (e.g., 1-1.2) OR one that is unusually high (e.g., 2.3) will often occur 5, to even 7-10 days BEFORE an actual bottom or top occurs. My rule of thumb is to look for a 5-day lag before a low call-put number suggests a potential bottom and a 5-day lag before a high call-put number suggests a top.

2007

S&P 500 (SPX): Don't be misled by the '9/19/13' date at top as this reflects the most RECENT Close on this daily chart as the chart goes back a decade.

Number 1 example sees reversal type PRICE action (most important!), but not a high RSI extreme in the typical 'overbought' range (that came earlier) BUT we do see a high Call-Put (CPRATIO) reading on my lower-most indicator.

Number 2 example sees a price peak at an approximate double top, + a high RSI in the overbought range + a daily peak in my CPRATIO indicator occurring FIVE days prior to the spike high; this was a NEW high for the move, followed by a Close below prior days and classic reversal type price action.

IN BETWEEN Example 1 and Example 2 is seen:

A 'classic' V-bottom + prior low RSI extremes + a low CPRATIO simultaneously with the V-bottom low.

2009 SPX

Another classic bottom 'set up' or bottoming pattern in the V-bottom low + an oversold RSI readings close to this bottom + 'oversold' (extreme bearishness) call-put readings just ahead of and simultaneously with the V-bottom low in SPX.

2010 SPX

I think by now you're getting the picture of what how the three components of reversal type price action ('first' & foremost) + an RSI extreme + a CPRATIO extreme. IT'S A TOP!!

In the case of the call put ratio, you see this tremendous spike in daily call volume (good 'timing' folks!) where call volume around the time of the top was approximately 3 times equities put volume that day!! This was extreme for saying 'extreme' but that's what happens sometimes in bullish sentiment, a lemming like thing or just the extreme direction human psychology can go at times. We all have gotten caught up in a strong consensus view at times.

2011 SPX - and multiple trend reversals

In 2011, as show again with SPX, we had some fairly rapid reversals of trend. Mostly price action was in sync with extremes in the Relative Strength Index (RSI) AND my CPRATIO indicator.

The bottom pattern seen in Example 2 looked pretty good for a bottom formation in terms of the minor rounding bottom and an oversold RSI + extremes in bearishness not warranted by the turn in prices.

However the rally into point #3 quickly 'failed' at a prior high and the subsequent rally set up a third top and after that the Index plunged; suggesting another rule of thumb: they 'slide' faster than they 'glide'!

I could go on with more examples of the interplay of price/trend reversals + RSI extremes + extremes in bullish/bearish 'sentiment' and of course I used examples were the interplay of price, RSI and CPRATIO were more or less in sync or didn't give a false 'signal' so to speak, but the foregoing examples give a reasonably good take on the use of my SENTIMENT model for options trading.


GOOD TRADING SUCCESS!