Watch for buyers to appear, as the breakdown may be an overreaction to a newsevent.
Moving Averages
Moving Averages (MAs): Help to confirm atrend by averaging past prices and calculatingtheir average. As a new unit of time passes,the MA drops the previous unit, so that theMA is continually updated.• It’s a lagging indicator. A trend won’t showup until well into the new direction.Requires the analyst to anticipate futuredirection.• Length can vary. The trader can useshorter MAs if the time horizon is short, orgo out longer to get a better sense ofoverall price history.Figure 9R.10 50-Day Moving Average• 10, 50, and 200 DMA are the mostExample (Courtesy of QChartspopular.(www.qcharts.com))–The shorter the time, the more erratic themovements.–Short-term traders use a 10 DMA, whileothers tend to rely on the 50 and 200DMA.• When two or more are used incombination the trader can spot a trendforming sooner.–When the shorter MA crosses over thelonger MA, an uptrend might be forming.–When the shorter MA crosses under thelonger MA, a downtrend may be forming.Figure 9R.11 50 DMA Crosses under200 DMA (Courtesy of QCharts(www.qcharts.com))
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Moving Averages: Simple orExponential?Some technical analysis tools callfor a simple moving average, whileothers, like the MACD or RSI,use an exponential average.
• Simple Moving Averages (SMA) work wellas a lagging indicator, but critics point outthat all days receive equal weighting inthe calculation.• Exponential Moving Averages (EMA) giveincreased weighting to the most recentday, thereby making the average reactslightly faster than a simple, orarithmetical moving average.Most traders use the SMA in chartconstruction. The EMA is utilized in variousoscillators.
Oscillators
Oscillators are used to anticipate themarket’s next move. They:• Utilize a fixed scale (0–100).• Use a centerline.• Work very well in a trendless market.• Are useful in spotting extremes:–Overbought and oversold.–Use a contrarian approach; the crowdis always wrong at the extremes.
Figure 9R.12Overbought/Oversold (Courtesy ofEquis.com)RSI Example
Figure 9R.13 RSI Divergence—Micron (MU) Stock Climbs While RSIDeteriorates, Stock Follows Later(Courtesy of QCharts(www.qcharts.com))
Relative Strength Index (RSI)• RSI measures overbought and oversoldextremes on a 0–100 scale; 30 is oversold;70 is overbought.• Use these two extremes to employ thecontrarian approach; get set for a reversal.• Divergences are easier to see when RSIdoesn’t confirm a price move up or down.• RSI uses an exponential average.• If RSI surpasses a previous high, it’s abullish sign; if it surpasses a previous low,it’s a bearish sign.
ROADMAP TO SUCCESSMoving Average Convergence/Divergence (MACD)
Figure 9R.14 MACD (Courtesy ofQCharts (www.qcharts.com))
Figure 9R.15 MACD Oscillator(Courtesy of QCharts(www.qcharts.com))
287MACD: Combines the two moving averagecrossover technique with some aspects of theoscillator. (Lagging indicator fused with aforecasting tool.)• Uses the difference between twoexponential moving averages of closingprices (most typically the last 26 and 11days); this is called the MACD line.• A 9-day moving average of the MACD lineis plotted and laid on top of the MACD.This is called the trigger line (or signal).• MACD watchers look for the trigger line tomove above or below the MACD line,especially when the oscillator is in theoverbought or oversold area. (See Figure9R.14.)• The MACD serves as a momentumindicator, too, as illustrated by its moveeither above or below the centerline.Momentum indicators are important tolook for as they show the intensity of theemotion behind the move.–If the MACD doesn’t move below thecenterline in a down move, the bearsdon’t have much force.–If the uptrend from an oversold positionfails to clear the centerline, the bullsdon’t have the power to climb higher,and the market is likely to fall back.• A histogram appears as a bar graph thatrises and falls on either side of the midline.The histogram is a graphic display of thedistance between the MACD and triggerlines, and visually aids the investor inidentifying reversals and momentum.• The MACD will diverge from the priceaction; the histogram will be the first signal(rising or falling), followed by the actualcrossing over/under of the trigger line.Examples• In Figure 9R.14, MACD signals reversalsin Dow Industrials of a sell-off in thespring of 2000. Look at the far right side ofthe graph as the Dow breaks throughresistance and heads higher. The MACDstayed above the centerline, indicating thedowntrend had lost momentum.• Figure 9R.15 shows a closer look at thecomponents of the MACD oscillator.
288Volume: Defined as the numberof entities traded during a definedtime period. It indicates theintensity of a move (the emotionallevel) of the market.
TECHNICAL ANALYSIS UNVEILEDVolume: An extremely valuable tool intechnical analysis, due to its simplicity andaccuracy. Technicians watch volume closely.Low volume indicates hesitation, reluctanceto commit. Strong volume shows highdemand to either buy or sell. These two traitscoupled with price action signal thefollowing:• Advancing Price Movement–Volume should increase as a stock risesin price. Failure to do this indicates alack of buyers’ conviction.–If price rises and volume declines, thisis called a divergence and indicatesthat the rally is suspect; caution isadvised.• Declining Prices–If a stock sells off on heavy volume,watch out! This is a signal ofinstitutional selling.–If a stock sells off on light or decreasingvolume, buyers are waiting for a betterentry point.
Figure 9R.16 Volume andDivergence (Courtesy of QCharts(www.qcharts.com))
Figure 9R.17 Increasing Volume(Courtesy of QCharts(www.qcharts.com))
• Capitulation–The final, exhaustive effort on the partof buyers or sellers.–This is the sign of a top or bottom—thebears (at the top) or the bulls (at thebottom) give up, exiting the market indroves.–Capitulation at a top is more difficult toidentify than at a bottom.Examples• Figure 9R.16 shows reluctance on thepart of buyers as the stock price rosewhile volume fell. This is called adivergence and indicates a lack ofcommitment one way or the other. Alsonote how the trend line broke support,and the gap down on big volumeoccurred shortly thereafter.• In Figure 9R.17, Oracle shows a risingtrend line in both price and volume. Evena pullback (shown in the center of thegraph) was on reduced volume, and theuptrend resumed for both the stock andthe volume.
ROADMAP TO SUCCESSBollinger Bands and Price Envelopes
Figure 9R.18 Price Envelopes(Courtesy of QCharts(www.qcharts.com))
Figure 9R.19 Bollinger Bands(Courtesy of QCharts(www.qcharts.com))
289Bollinger Bands and Price Envelopes: Similarin that they show a range above and below amoving average line.• Bollinger bands calculate standarddeviations above and below the mostrecent range of the stock or index.• When a stock reaches the upper band, iteither continues to rally or turns down,signaling a possible reversal and thus atime to sell or go short.• Bands are another way to view volatility ofstock or index—when the bands narrow,the stock has gone quiet. This is a goodtime to buy options. (You want to buyoptions when volatility is cheap and selloptions when the volatility is expensive—when the Bollinger bands are wide apart.)• Price envelopes track a moving average aswell, but use a fixed percentage added toand subtracted from the moving averageto calculate the envelope or price bands.
10Sentiment Analysis Essentials
For years there have been two main approaches to market research: fundamental andtechnical analysis. Both schools of analysis offer investors a means of studying themarket in terms of present and past performance as reflected by facts. However,these two approaches don’t take into account the mass psychology of the investmentcommunity. To fill this gap, a third approach—sentiment analysis—is slowly gainingin popularity. Sentiment analysis gauges investor sentiment by analyzing the groupconsciousness in the marketplace, using various market criteria that define the market’s state of mind, if you will. Be advised that the meaning of these criteria is subjective. Many market analysts, however, do agree that certain measurements stronglysuggest a predominantly bullish or bearish tone to the market.Sentiment analysis: The process of measuring investor attitudes toward the securities markets. The goal is to determine if investors, or the crowd, are bullishor bearish toward the market. When studying market sentiment, the analyst often takes a contrarian approach. That is, if investors are predominantly bullish,the analyst will be bearish (sell stocks). If, on the other hand, the crowd is bearish, the analyst will turn bullish (buy stocks). Examples of indicators used in sentiment analysis include: survey of newsletter writers, amount of margin debt,mutual fund cash positions, short sales, and others. Sentiment analysis requiresthe combination of several measurements to reach a conclusion; that is, it requires interpretation!
The stock market is arguably the most graphic example possible of the world’s collective consciousness—a never-ending, seesaw battle between buyers and sellers, optimists and pessimists. Some days, it is a raw display of emotion as fear and greed inall their respective glory play themselves out on the battlefields of various exchanges.290
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Investors and traders can either take advantage of these emotional swings or beswept along with them—buying when they should be selling, and selling at theworst possible times (when smart money is buying). Herd tactics, the notion of buying when everyone else is buying and selling when everyone else is selling, simplydoesn’t, and cannot, work, especially during extreme highs or lows in the indexes.The axiom of “buying low and selling high” may be easy to understand; but implementing it is another story altogether. When everyone around you is bursting withenthusiasm, as is most often the case in a deliciously profitable bull market, mosttraders will tell you that getting out runs contrary to what their heart (and net worth)is saying. Conversely, buying when “blood is running in the street” takes nerves ofsteel. But it’s this contrarian way of thinking that can help you to avoid buying thetops and selling the bottoms.The contrarian investor does the opposite of what the generalconsensus may be. Even though this may sound suicidal,time has repeatedly proven this strategy’s wisdom.
Since emotions often dictate the course of a trader’s action, the study of emotion(sentiment analysis) as it pertains to the buying and selling of stocks has produced anumber of sentiment indicators. These indicators seek to measure the degrees oflevels of fear and greed (optimism and worry) in the marketplace at any given time.The most revered traders are said to act without emotion. This characteristic is considered an ideal, sought and actually attained by some market participants; but theconsistency with which these supertraders are able to maintain this ice-water-in-theveins mind-set varies widely. One thing is certain: It’s far easier to make a decisionwhen you’re out of the market than in it!When this scenario is spread over an entire market, you’ll see some people buying and some selling, some at the right time and some at the wrong time—but all atthe same time. Hence, market sentiment and psychology offer vital clues when determining the future direction of the market. History has shown time and again thatgreat bull markets have begun when market sentiment is at its nadir. Doomsayerspound their drums as they warn of impending disaster. The problem with this scenario is: If everyone has sold who’s going to sell, what would make the market dropany further? Fear keeps many investors on the sidelines as the indexes reverse andpower upward until the doomsayers have been silenced. The coast appears clear andthe last worrier/pessimist decides it’s now safe to invest. This most often signifiesthe top, as the last of the nervous Nellies enter the market. With everyone happy andfully invested, you’d think the market would spiral ever skyward. The problem withthis scenario is: If everyone is invested, who’s left to buy?This case of extreme optimism is the hallmark of a market top. As the media pronounces ever higher highs, new offerings are brought to the table to take advantageof this optimism. Investment dollars are increasingly absorbed until there is no liquidity (relatively speaking), and the erosion begins. Only with the luxury of hindsight can we see that the ensuing downtrend in the market began right after a huge up
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day—probably the most obvious measure of optimism available. Volume was upsharply, and investors were seemingly buying in at any price. Time and again, thistype of capitulation is nurtured by extreme exhibitions of fear (shown at market bottoms), and greed (a sign that a top has been reached), and clearly marks major turning points in the market. Beware the panicked trader who can’t afford to be leftbehind at the top or loses any long-term outlook, throwing in the towel at the bottom.Capitulation: The emotional climax (peak) that ultimately exhausts the momentum of the current trend, signaling either a top or bottom in the market.
SENTIMENT INDICATORSMore often than not, the majority of investors (the crowd) and traders are right intheir market analysis—their trend identification is correct. Just about anyone whopays even a modicum of attention to news reports on market activity could tell youthings are good (the market’s going up) or it’s bad (the market’s heading south). Butwhen it comes to extreme highs and lows, the majority of people are wrong. Only aminority of money managers and traders have enough savvy to be able to correctlyidentify true market tops and bottoms. I cannot emphasize the power of emotions atthese extremes, because facts about earnings or interest rates or the economy confirm the predominant emotion of the time, which makes selling seem like a foolishmove or buying an absurd risk.Market tops: A high point in stock prices generally measured by one or more ofthe senior averages (i.e., the Dow Jones Industrial Average, the S&P 500, andS&P 100), which is then followed by a period of declining prices. In general,during market tops, investors are optimistic about the future course of stockprices and there is a large amount of public participation in the stock market.Market bottoms: A low point in stock prices measured by one or more of the senior averages, which is then followed by a period of advancing prices. Traditionally, during market bottoms, public participation in the market is low andthere is a large amount of pessimism with respect to stock prices.
How do they determine these turning points? By reviewing a number of technical and sentiment indicators for clues that the trend is shifting from a bullish to abearish one or vice versa. But the clues are more contrary than coincidental; extremely bullish indicators are actually bearish signals.In the fall of 1998, the markets were being buffeted by several potentially disastrous events: Russia’s default on a bond, fears of financial crises in Asia and LatinAmerica, and the near collapse of a major U.S. hedge fund had sent the markets froma high of 9,368 (DJIA), reached on July 20, to a low of 7,400 on September 1—a
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21% haircut. The Dow hit an emotional bottom (a capitulation) a month or so later onOctober 8, before it turned and headed up in what, in retrospect, was one of the greatest bull runs of all time. It should be noted that the market had rallied a bit throughSeptember, so that when it dropped again, the pessimism meter went off the charts.How was it possible for financial markets, in the face of so much uncertaintyand outright fear, to stage such an impressive rally? Let’s look at some of theeveryday tools (sentiment indicators) traders use to gauge the extent of fear andgreed in the market.
The Volatility IndexThe measure of volatility in the market is a key factor in determining its state ofmind, if you will. In its most basic form, volatility is defined as a statistical measurement of a stock’s price change (regardless of direction) represented by a percentage. As mentioned earlier, I prefer to think of it as the speed of change in themarket. A stable market moves slowly and a volatile market moves quickly. Impliedvolatility approximates how much the market thinks an option’s price will move.Higher implied volatility (IV) suggests bigger moves, and is also reflective of thedegree of optimism or pessimism in a stock, option, or the market in general.The CBOE Volatility Index (ticker = VIX) computes implied volatility of fourS&P 100 (OEX) option contracts in the two front months (in the case of October,the two front months would be October and November), one call and one put contract just out-of-the-money (OTM), and one call and one put just in-the-money(ITM). This index is updated continuously and followed by traders almost asclosely as the other major indexes like the Dow Industrials. Since VIX reflects theimplied volatility and premium paid for OEX options, it can rise dramatically during periods of uncertainty as investors scramble to hedge portfolios with OEX puts.For example, while VIX fluctuated between 23% and 35% throughout most of1999, it hit a high of 60% during October 1998’s climactic sell-off.The normal range for the VIX is between 20 and 30. When the VIX either exceeds or drops below this range, a mood of either pessimism (a high VIX), or optimism (a low VIX) prevails. A low VIX is achieved by excessive call contractbuying (i.e., the majority of people expect the markets to move higher still); a highVIX reading is indicative of pervasive put buying, or pessimism. Wall Street hasmany axioms or clichés. However, there’s one I consistently live by, and it makesthe VIX level easy to understand: When the VIX is low (<20), it’s time to go. Whenthe VIX is high (>30), it’s time to buy.
CBOE Volatility Index (VIX): The weighted average of the implied volatilities ofeight OEX puts and calls with an average time to maturity of 30 days. Updatedin real-time using OEX option bid-ask quotes, VIX generates up-to-the-minuteestimates of index option volatility.
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Figure 10.1 clearly shows the correlation of VIX levels and major turning pointsin the market. When pessimism was at its highest, an abundance of put buyingmarked the lowest trading points of the market. People wanted out, period. Whenthere are no more sellers, there’s nowhere to go but up. Think about it. If an entiregroup of stock owners—those with what I’ll call weak hands—sell (their fear beingso extreme that they want more than anything to be in cash or some other safehaven), and the remaining stockholders are willing to ride the storm out, the sellingstops, right? Of course there are still some sellers, naturally; but the number of buyers and the degree with which they buy, dollar-wise, sends the market north. If people weren’t selling at 50, for example, after riding XYZ down from its highs around100, why would they sell when it’s going up again? No stock for sale at 50 meanshigher bids, and voilà! the next bull market leg has begun.Using the fall of 1998 as an example again, the newspapers were full of storiesdescribing possible consequences of a collapse of Brazil’s economy, which wouldworsen the already shaky footing Russia was dealing with, or perhaps it wouldwork in the opposite direction. Bank stocks with foreign exposure were beingdumped at wholesale prices by some very smart people, and who could blamethem? There was genuine concern, so that when the final sell-off occurred in October, most investors and traders were prepared to ride the entire U.S. economy rightdown the drain. The VIX hit an unheard-of high of 60! (Remember, 30+ is generally considered a good entry point!) There was extreme volatility during this period,with the VIX bouncing between 30 and 60. This level of fear when coupled withmarket volatility and a global economic crisis served as the basis for a move in theNasdaq from 1,300 to over 5,000 just over a year and a half later! Aggressive callbuying, low put/call ratios, and a falling VIX are all symptoms consistent withmarket-topping activity—theoretically, a prelude to increased volatility. To giveyou a visual picture, check out Figure 10.2, a chart of the Nasdaq Composite index,and Figure 10.3, a chart of VIX for the same period.
Major Date VIX Turning PointsOctober 1997July 20, 1998October 8, 1998January 11, 1999March 4, 1999May 14, 1999July 16, 1999August 5, 1999October 15, 1999January 28, 2000April 14, 2000Figure 10.1
BottomTopBottomTopBottomTopTopBottomBottomBottomBottom
Table of VIX Tops and Bottoms
54.6016.8860.6326.3828.1525.0118.1332.1232.0629.0941.53
IMPLIED VOLATILITY
Figure 10.2
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Nasdaq Composite 1998 (Courtesy of QCharts (www.qcharts.com))
IMPLIED VOLATILITY AS A MEASURE OF INDIVIDUALSTOCK SENTIMENTThere are three basic dimensions to the value of an option:1. The price of the underlying stock.2. The time left to expiration of the contract.3. The implied volatility of the option itself.Implied volatility is a computed value that measures an option’s premium, ratherthan the underlying asset. The fair value of an option is calculated by entering thehistorical volatility of the underlying asset into an option pricing model (BlackScholes for stocks). The computed fair value often differs from the actual marketprice of the option, depending on the level of interest in the underlying stock.The best way to analyze whether an option is undervalued or overpriced is to compare its current implied volatility level to its historical volatility levels. The differencebetween an option’s historical volatility and implied volatility provides important cluesas to market sentiment. For example, if the implied volatility of an option is higher thanthe historical volatility, the option is most likely overvalued. In this scenario, if theprice of a stock increases, but the implied volatility of the option decreases, you may
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Figure 10.3
SENTIMENT ANALYSIS ESSENTIALS
Volatility Index 1998 (Courtesy of QCharts (www.qcharts.com))
lose money even though the stock moved in your favor. This is a sign to sell options. Ifimplied volatility falls below historical volatility, the volatility ratios are low and theoptions are likewise undervalued. If the price of the stock falls and the implied volatility increases, option premiums will increase. This is a good time to buy options.Without this comparison, the current value of an option’s implied volatility tellsyou very little. For example, let’s say a stock’s options on a given day have an implied volatility of 100%. Are the options expensive? What if, for the past year, thesame stock’s options have registered implied volatilities from 110% to 230%?Given that history, I think we would all agree that 100% should rightly be considered small and hence the options cheap.If the implied volatility of a stock’s options moves below or above the actual statistical volatility of the stock, it may create a volatility crush, which, in turn, triggersprice movement. Options on stocks often have incredible swings in their impliedvolatilities. Figure 10.4 shows a six-month price chart for Motorola (MOT) andFigure 10.5 reveals Motorola’s implied volatility chart.Figure 10.5 clearly illustrates the herd mentality of volatility valuations. Peaksand troughs aplenty here, as traders rush in when there’s news, unusual price action,or some other force at work. Sometimes traders will jump in just because there isunusual price action. There’s a group of traders known as momentum traders (see
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Figure 10.4 Six-month Price Chart for Motorola (MOT) (Courtesy ofOptionetics.com)
Figure 10.5
MOT Six-Month Implied Volatility Chart (Courtesy of Optionetics.com)
Chapter 12) who look for these kinds of swings. They look for conditions in whichpressure begins to build, hoping for an explosive up or down move. It is in thissharp upward move that the premium (IV) of an option goes up as traders rush toparticipate by using the leverage of options. As momentum begins to subside, theyget out. The sell-off not only drops the stock price but also the premium drops, too,a double whammy that causes many option traders to lose money quickly. It’s theherd mentality again that creates this high premium. The floor brokers pump up thepremium when the buying gets heavy and the stock attracts attention, and then theydrop the premium as everyone tries to get out.
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Momentum traders: Momentum refers to the tendency for stock prices to movein one direction over time. Momentum traders attempt to capture profits fromthis tendency by analyzing a stock, not based on fundamental criteria, but onthe strength of the stock price movement to the up or downside. If a stock ismoving upward rapidly over a long period of time, it has powerful upward momentum, and traders will buy the stock in anticipation of further price appreciation. If, on the other hand, the stock price has been falling over a long period oftime, the stock has powerful downward momentum and momentum traders willsell it short to capture profits as the stock price falls further.
By using the contrarian approach, (trading against the majority view), you oftencan profit by the subsequent decrease in implied volatility by going against thecrowd. A good rule of thumb to remember about volatility is: Buy low volatility;sell high volatility.A good place to find these kinds of stocks is by using the Optionetics.comPlatinum service. The Platinum service offers traders an extensive selectionof tools including a rank engine (just go to the “Ranker: High/Low IV”section) that sorts through historical data to find stocks that are explosivelymoving, cheap options, and a variety of implied volatility versus statisticalvolatility settings. The Platinum service offers a two-week free introductoryoffer to help you get started on finding explosive trading opportunities.
PSYCHOLOGICAL MARKET INDICATORSInvestor’s Business Daily (www.investors.com) offers a variety of sentiment indicators in its “General Market and Sectors” section, currently near the back of the firstsection. There is a table of psychological indicators printed daily in the IBD that canprovide some essential numbers of sentiment analysis (see Figure 10.6).
Public/NYSE Specialist Short SalesA short sale is a trade where a person or institution will actually borrow stock tosell, with the idea of buying it back at a lower price. If the number here is above 0.6,it is believed to be bullish; less than 0.35 is bearish. Again, the crowd is consideredto be wrong at market extremes, and these two levels would indicate extreme levelsof pessimism or optimism.
Ratio of Price Premiums in Puts versus CallsIf put premiums are more expensive than call premiums, puts are most likely experiencing a higher demand, which increases their volatility. A rise in volatility subsequently pumps up the price. A higher demand for puts is a sign that a higher
PSYCHOLOGICAL MARKET INDICATORSPsychologicalMarket IndicatorsPublic/NYSESpecialist ShortSalesRatio of PricePremiums inPuts versus CallsMutual FundShare Purchases/RedemptionsNasdaq DailyTrading Volumeas % NYSE DailyVolumeNumber ofStock Splits inIBD 6000 (prior30 days)New Issues inLast Year as %of All NYSEStocksPrice-to-BookValue of DJIAPrice-to-EarningsRatio of DJIACurrent DividendYield of DJIA
Figure 10.628, 2000)
Current9/28/00 High
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0.99
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0.56 10/31/97
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165% 234% 11/26/99 79.8%
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20.2% 31.7%
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9/4/98 234% 11/26/99 105% 10/27/99
40 11/16/96
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43 10/22/99
11/5/96 12.0% 5/24/99 22.3%
4/14/00 14.2%1/14/00
6.06
8.29
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