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The same analysis is repeated for the CBOE index putto-call ratio, but the equation considers only index optionsSENTIMENTAL ANALYSIS The stock market is a fascinating place. It is particularly interesting in that the day-to-day fluctuations reflect the views, expectations, and forecasts of investors around the world. Indeed, it is an arena in which the final outcome depends not on one individual decision maker, but on the activity of millions of investors. Given that market moves are due to decisions of a mass of market participants, or the crowd and not one individual decision maker, history is replete with episodes of crowd or mob behavior. Basically, under certain decision-making situations, the individual may act quite rationally, but as part of a crowd, will act based on feelings and emotion. In the words of Humphrey B. Neill: Because a crowd does not think, but acts on impulses, public opinions are frequently wrong. By the same token, because a crowd is carried away by feeling, or sentiment, you will find the public participating enthusiastically in various manias after the mania has got well under momentum. This is illustrated in the stock market. The crowdthe publicwill remain indifferent when prices are low and fluctuating but little. The public is attracted by activity and by the movement of prices. It is especially attracted to rising prices. (The Art of Contrary Thinking, 1963). As an example, take the contagion that spread throughout global financial markets in the fall of 1998. The fact that the sell-off of one stock market in one country eventually led to a drop in another, and then another, was an example of extreme crowd behavior. It was labeled contagion: defined as the ready transmission of an idea, response, emotion, and so on. However, given that global financial markets recovered toward the end of 1998 and early 1999, obviously the panic selling and drop in global financial markets was overdone. In that case, it was the opposite of a mania, but still an example of crowd psychology in its worst formfear, panic, and disengagement. Given the nature and impact of crowd psychology on financial markets, many traders use sentiment analysis to gauge the overall attitude of the mass of investors, or the crowd. Studying market sentiment, in turn, is an endeavor in contrary thinking. In other words, one of the premises underlying the study of sentiment data is that, during certain periods of time, it pays to go against the masses. Specifically, when market sentiment becomes extreme in one direction or another, the contrary thinker will act in a manner opposite to the crowd. For example, at the apex of panic selling during the global financial crisis of 1998, the contrary thinker armed with an understanding of sentiment data may well have turned into a buyer: just as the crowd was getting rid of shares. Indeed, when the market is gripped with fear and panic, it usually turns out to be the best buying opportunity. An often-heard saying in the stock market is that investors are right on the trend, but wrong at both ends. In a rising or bull market, investors are better served buying shares. In a declining or bear market, the trend is downward and it is a better time to sell. In short, during significant market trends, it is more profitable to go in the direction of the market rather than contrary to it. So the crowd is not always wrong. The turning points, however, often catch investors unaware. Sentiment analysis offers a variety of tools for identifying the extreme crowd behavior or the ends. Lets start by taking a closer look at put/call ratios. Put/call ratios are widely used and easy to obtain. All of the necessary data is available on the Chicago Board Options Exchange web site (www.cboe.com). As the name implies, the put/call ratio is computed by dividing puts by calls. It can be done for shares or index options. I focus on two put/call ratios: the CBOE total put-to-call and index put-to-call ratios. While the CBOE put/call ratio uses the total of all option trades on the Chicago Board Options Exchange, the index ratio considers only index trading. For example, February 12, 2004, 508,743 put options and 916,360 calls traded on the CBOE. So the put-to-call ratio was .56 (or 508,743/916,360). The same analysis is repeated for the CBOE index putto-call ratio, but the equation considers only index options. The ratios are available daily at the CBOE web site. Put/call ratios are used as a contrary indicator. Since calls make money when shares or indexes rise, they often represent bullish bets on the part of investors. Conversely, puts increase in value when a stock or index moves lower and, therefore, reflect bearish bets. So when the put/call ratio increases, it suggests that there are a greater number of puts traded relative to calls, and market sentiment is turning bearish. When it falls, call buying is increasing in comparison to put buying. Again, studying put/call ratios is an exercise in contrary thinking. Specifically, if most market participants, or the crowd, are buying puts, it is a sign of negative sentiment and reason to turn bullish. Conversely, a low put/call ratio is interpreted as a market negative since the crowd is excessively bullish, but probably wrong. In practice, readings of .50 or less from the total put-to-call ratio are a sign of heavy call activity and extremely bullish sentiment. In that case, the contrarian would turn more cautious or bearish. On the other hand, readings of 1.00 or more are a sign of excessive bearishness and reason to be bullish. The index put-to-call ratio will rise above 2.00 when investors are too bearish and drop below 1.00 when bullish sentiment is extreme. Adviser sentiment, which is used to measure excessive bearish and bullish positions, is one of the more popular contrarian indicators and is certainly one I employ. If adviser bearish sentiment is greater than 60 percent, this is a signal that a possible bottom is forming. If adviser optimism is greater than 70 percent, this signals a market top. The mutual fund liquid assets ratio is based on the premise that cash balances rise as the trend nears a bottom when increased buying power exerts a bullish effect. If buying power is greater than 10 percent of balances, this is bullish. The Investment Company Institute (ICI) releases the number monthly. The first cousin of this indicator is customer credit balances and is based on the fact that the cash balances rise or fall as the market bottoms or peaks. The short interest ratio indicator consists of ratios of short interest to average daily trading volume. Readings above 1.75 are bullish and ratios under 1.0 are bearish. A related indicator is odd-lot short sales, which typically are wildly speculative in the wrong direction. The final three contrarian indicators I look at are the over-the-counter (OTC) relative volume, market P/E ratio, and the Dow Jones Industrial Average dividend yield. OTC volume breakouts above 80 percent provide bearish signals of excessive speculation. Price-earnings ratios of 5 and 25 are approximate lower- and upper-trend boundaries. DJIA yields get as low as 3 percent at market tops and as high as 18 percent at market bottoms. The different numbers I have used for quantification purposes are typical rules of thumb used by most contrarian traders. I basically use them as a ballpark figure versus an absolute. They will change through time and should be considered in light of their long-term trends. As far as finding the latest readings for these indicators, information can be found in Barrons, Value Line, and Investors Business Daily, as well as on a multitude of Internet sites. In conclusion, there is a wide variety of sentiment tools that can be used to enhance your trading, especially if you are interested in becoming a contrarian trader. The premise holds that the crowd is not always wrong, but invariably on the wrong side of the market during major turning points. The goal behind using sentiment analysis, therefore, is to identify extreme cases of bullishness or bearishness and then trade in the opposite direction because the major turning points generally turn out to be the most profitable trading opportunities. Table 17.1 lists key contrary indicators and other technical trading tools. The rightmost column shows how each indicator can be used by market technicians to keep up with changing market trends. The market is always going to bounce around, and this constant fluctuation may indicate that theres never an exactly right time to enter a trade, but there will always be a time thats better than another. Professional traders use timing and technical indicators to secure the best moment of entry and exit. They take advantage of the markets swings rather than letting volatility take advantage of them. Thats why it is so important to learn how to use timing indicatorsto put the odds in your favor and dollars in your trading account. OPTIONS AND THEIR BUILT-IN SENTIMENT INDICATORS The utilization of sentiment indicators has been common in the stock, futures, and options market for a long time. However, the difference for the options market is that it inherently possesses its own sentiment indicators and does not have to look outside to gauge or measure investor feelings. The inherent sentiment indicators I am referring to come in the form of implied volatility, option trading volume, option open interest, and put/call ratios. All of these reveal important sentiment type information about the markets. First, implied volatility is a calibration of a stocks volatility as implied by the current price of the option. Many times it is referred to as the fear factor as it gauges the level of concern investors might have in the markets at a particular time. An options implied volatility is an approximation of the underlying equitys volatility in the future. Estimating the level required to arrive at the options current value gives us implied volatility. To determine whether implied volatility is exhibiting investor fear or complacency, we compare it against its historical volatility levels. Historical volatility, also known as statistical volatility, gauges a stocks volatility based on the equitys past price action. Historical volatility is constructed using the standard deviation of a stocks price changes from close-to-close of trading for a specified time period. If an options implied volatility is greater than the statistical volatility, the option is considered expensive or overvalued. The type of sentiment reading would indicate to the option strategist that they should consider selling options. If an options implied volatility is less than historical volatility then the option is considered cheap or undervalued. In this scenario, the options trader would pursue a strategy where he or she would buy options. This comparison is necessary because just relying on implied volatility alone doesnt really provide you with enough information. Additionally, there are two other perplexing ways to use options for ascertaining investor sentiment: option trading volume and open interest. Option trading volume is the amount of option contracts traded in one day recorded at the market close. The interpretation is based on the idea that put purchasing is bearish and buying calls is bullish. Put volume divided by call volume determines if a specific market has a bullish or bearish sentiment. Option open interest is the number of outstanding contracts that are available on a specific option series. Monitoring the open interest statistics of an option allows an investor to judge the relative demand of an option. An increase in an options open interest means there are additional purchasers for that option. On the other hand, a reduction in the open interest of an option indicates fewer buyers and more sellers than previously. Just as with option volume comparing the put options open interest with the call options open interest generally indicates the underlying equitys bullish or bearish bias. Finally, you can look at how bearish or bullish a particular market is by monitoring the ratio between put premiums and call premiums. This is by far the most popular option sentiment tool of the mix. In general, if there is a lot of put buying compared to call buying the premium on puts will be higher, which signals a bearish environment. Conversely, if call buying exceeds put buying, this increased demand pushes call prices higher signaling a bullish sentiment. These inherent sentiment indicators are yet another illustration of the amazing flexibility of an option. One thing to note though before employing the indicators as definite buy and sell signals: Sometimes an upsurge in open interest can be attributed to a large institution hedging a position. As with any technical tool, look to get confirmation from one or two additional indicators before locking yourself into a directional bias. |
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