feeling, or sentiment, you will find the public participating enthusiastically in various manias after the mania hasgot well under momentum. This is illustrated in the stock market.The crowd—the public—will remain indifferent when prices arelow and fluctuating but little. The public is attracted by activityand by the movement of prices. It is especially attracted to risingprices.*Given the nature and impact of crowd psychology on financial markets, many market analysts rely on sentiment analysis to gauge the overallattitude of the mass of investors, or the crowd. Studying market sentiment, in turn, is an endeavor in contrary thinking. In other words, one ofthe premises underlying the study of sentiment data is that, in the longrun, it pays to go against the masses. Specifically, when market sentimentbecomes extreme in one direction or another, the contrary thinker will actin a manner opposed to the crowd. For example, at the apex of panic selling during the global financial crisis of 1998, the contrary thinker armedwith an understanding of sentiment data may well have turned into abuyer—just as the crowd was getting rid of stock like turkeys at Thanksgiving. Indeed, when the market is gripped with fear and panic, it usuallyturns out to be the best buying opportunity.An often-heard saying in the stock market is that investors are “righton the trend, but wrong at both ends.” In a rising, or bull market, investorsare better served buying stocks. In a declining, or bear market, the trend isdownward and it is a better time to sell. In short, during significant markettrends, it is more profitable to go in the direction of the market rather thancontrary to it. So the crowd is not always wrong. The turning points, however, often catch investors unaware. Hence, sentiment analysis is really a
*Humphrey B. Neill, The Art of Contrary Thinking (Caldwell, ID: Caxton Printers,1992; first printing 1954).
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tool for identifying the extreme crowd behavior, or “the ends.” Thepremise holds that the crowd is not always wrong, but invariably on thewrong 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 (a contrarianstrategy) because the major turning points generally turn out to be themost profitable trading opportunities.In many cases, capitalizing from various market anomalies such asthe price-to-earnings effect is a contrarian strategy. It is often a bet thatpast losers will become winners and the previous winners will becomelosers. Contrary thinking, in turn, requires an analysis of the prevailingcrowd psychology, which is also known as sentiment analysis. History hasshown that the investing crowd will be almost unanimous in its marketoutlook, just as the market is ready to turn in the opposite direction.For example, market tops are generally accompanied by euphoria,optimism, and bullishness because prolonged periods of rising prices, ora bull market, generate large amounts of wealth and a general sense ofwell-being. Unfortunately, that is when everyone has already put moneyin the market and there are very few buyers left. Market bottoms are generally characterized by a mass feeling of negativity, bearishness, and despair. At that point, even die-hard bulls have thrown in the towel and thesubsequent absence of sellers sets the stage for a move higher in thestock market.How do we know if the crowd is primarily bullish or bearish? Thereare a variety of tools that can be used to gauge market sentiment, andsome come directly from the options market. They include put-to-call ratios, the ISE Sentiment Index, and Bollinger’s Put Volume Indicator (PVI).
Put-to-Call RatiosWhen traders talk about the put-to-call ratio, it is often in reference to theCBOE put-to-call ratio. This is a tool that tracks the trading activity on theoldest U.S. options exchange—the Chicago Board Options Exchange. It isone of the first indicators traders turn to when looking for signs of excessive amounts of greed or fear in the market. The actual ratio is simply thetotal number of puts traded divided by the number of calls traded on theCBOE and it is updated daily. For instance, if put volume totaled 316,318on a given day and call volume equaled 509,982, the P/C ratio was 316,318divided by 509,982 or 0.62. The daily numbers can be found every afternoon at the CBOE web site (www.cboe.com). It is also updated throughout the trading day.Traders look for extreme readings in the P/C ratio to signal high levels of bullish sentiment or bearish sentiment. Often there is a bit more
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call activity than put activity on the CBOE and the ratio stays below 1.00most of the time. However, if the ratio rises above 1.00, it indicates thatput volume is greater than call volume during that trading session.Therefore, if the CBOE put-to-call ratio remains below 1.00 for severaldays and then rises above 1.00, it is a sign that put activity is on the rise.In addition, since most options trades are bought to open, and not soldto open, we can be fairly confident that a lot of the volume representspurchases. So when the put-to-call ratio rises, it is often a sign that putbuying is on the rise.However, understanding that put or call volume is increasing is notenough. The put-to-call ratio gives trading signals when it reaches extremes. From a contrarian view, investors and options traders generallybecome extremely bearish when stocks have already suffered a large decline and are ready for a move to the upside. At that time, the CBOE putto-call ratio will spike higher. Recently, extreme readings from the ratiohave occurred when it rises above 1.25. Therefore, readings of 1.25 orgreater are signs of oversold conditions and traders should be on the lookout for a reversal to the upside.The opposite holds true when the CBOE put-to-call ratio falls tolows. When the indicator drops below 0.50, it is a sign that bullish sentiment is quite high because calls are two times more active than puts.When this happens, some contrary thinkers will take it as a sign that optimism is extremely high and investors have become too bullish. Thisusually occurs at or near the end of an advance, and when the majorityof investors have already committed most of their working capital tothe market. So when the ratio drops below 0.50, it is a sign of overbought conditions and traders should be on the alert for a bounce to thedownside.
Equity-Only Put-to-Call RatioIn order to get greater insight into the P/C ratio, it is sometimes useful toseparate the index activity from the stock option activity. Each day, hundreds of thousands of contracts trade on the Chicago Board Options Exchange. Some of the activity is stock option activity, but some of thetrading involves index options like the S&P 100 Index ($OEX), the DowJones Industrial Average ($DJX), or the NASDAQ 100 Index ($NDX).Sometimes the trading in the index market can be much different than inthe stock options. Therefore, separating out the equity-only ratio cansometimes provide additional insight into what traders are doing.Like the CBOE put-to-call ratio, the equity-only ratio indicates that investors are predominantly bullish on the market when it falls to low levels. For instance, when it falls below 0.40, it is a sign that call options on
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individual stocks are much more active than equity put options. Conversely, high readings from the equity put-to-call ratio often occur nearmarket bottoms. Recently, the ratio has stayed below 0.90 most of thetime. Readings of 0.90 or more are consistent with an oversold market.Smart Money and Dumb MoneyWhen using sentiment analysis, some traders separate the trading crowdinto two groups—the smart money and the dumb money.Smart Money: These are groups of investors that have a history of accurately timing the market. They are generally large investors that take bigpositions. Examples include commercial hedgers and OEX traders.Dumb Money: Groups of investors that have historically had miserabletrack records at timing the market. These are the groups to bet against.They include small speculators, large speculators, small equity optionplayers, and newsletter writers.
All-Exchange Put-to-Call RatioHistorically, the CBOE put-to-call ratio has been the most widely followedindicator for market sentiment in the options market. However, todaythere are six exchanges competing with one another. As a result, the options trading volume on the CBOE no longer represents the largestamount of activity. In fact, the International Securities Exchange (ISE)sees more volume than the Chicago Board Options Exchange.In order to get a look at what is happening throughout the entire options market, the put-to-call ratio can be computed using data from all exchanges. It is updated daily at the Options Clearing Corporation (OCC)web site (www.optionsclearing.com). Table 10.4 shows an example of thedata from the OCC during the first half of October 2005.Although it has a limited track record, the all-exchange put-to-call ratio indicates overbought conditions when it falls below 0.50 and oversoldmarket conditions when it rises above 1.00. For example, during the firsthalf of October 2005, the ratio rose above 1.00 on three different occasions. The high relative levels of put volume indicated increasing amountsof bearish sentiment or pessimism. That, in turn, paved the way for a market bottom. The Dow hit a low on October 13 and was trading at four-anda-half-year highs less than two months later.
Index Put-to-Call RatiosIn 1973, the CBOE created the first standardized stock option contractsand began trading these new derivatives on the exchange. Prior to that,
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TABLE 10.4 OCC Data SampleDate
OCC Total
2005
Calls
Puts
Total
P/C Ratio
10/3
3,242,722
2,242,188
5,484,910
0.69
10/4
3,695,645
2,678,623
6,374,268
0.72
10/5
3,874,087
3,657,722
7,531,809
0.94
10/6
4,464,105
4,444,739
8,908,844
1.00
10/7
3,201,374
2,670,379
5,871,753
0.83
10/10
2,991,914
2,745,909
5,737,823
0.92
10/11
3,764,185
3,474,172
7,238,357
0.92
10/12
4,219,175
4,547,705
8,766,880
1.08
10/13
3,990,313
4,296,166
8,286,479
1.08
10/14
3,609,426
3,137,210
6,746,636
0.87
10/17
3,943,341
2,870,856
6,814,197
0.73
option trading was largely unregulated and inefficient. Ten years after thelaunch of stock option trading, on March 11, 1983, the CBOE listed thefirst options contract on a broad-based index. The options were based onthe S&P 100 Index (OEX). Therefore, the OEX was the first index to haveoptions linked to its performance.Through the years, the OEX options contract grew in popularity. In1998, options trading on the OEX remained brisk. During that year, theS&P 100 averaged 130,000 contracts a day, and that proved to be the mostactive of any index contract. Since then, however, the competition fromother indexes has led to a dramatic decline in market share for the OEXtrading pits. Today, most index traders prefer to trade the Qs, diamonds,SPDRs, the S&P 500 index, or a host of other index products.Although OEX options are not as active as they once were, the indexand its options remain one of the most widely followed by index traders,especially the old-timers. For that reason, the trading activity associatedwith OEX options contracts can still be telling. That is, given the historyof OEX options trading, the index has become not only a vehicle forplacing bets on the direction of the market, but also a window intoinvestor sentiment.When a large number of OEX puts are trading, it serves as an indication that the old-timers are getting bearish or are hedging their bets. WhenOEX calls are more active than puts, OEX traders are predominantly
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bullish. The OEX put/call ratio is a tool for quantifying relative levels ofbullish or bearish sentiment using OEX options trading information. Theratio appears weekly in Barron’s, but it can also be computed daily. Thecalculation is straightforward:OEX put/call ratio = Total OEX put volume ÷ Total OEX call volumeUnlike the total and equity put/call ratios, the OEX put/call ratioshould not be considered in a contrarian manner. Perhaps due to itshistory or due to the generally higher premium (cost) of index optionsas opposed to equity options, OEX options appear to attract a moresophisticated trader—those who are a bit more adept at timing themarket.So the OEX is not used as a contrarian indicator but as a confirmationtool. If the ratio spikes higher, then S&P 100 Index options traders areturning more defensive or cautious. In 2005, the OEX put-to-call ratio averaged 1.25, as OEX put volume consistently outpaced OEX call volume.Extreme readings from the ratio tend to occur above 3.00. Meanwhile, lowreadings from the ratio indicate that traders in the OEX pits are gettingmore bullish. For instance, on October 6, 2005, the same day the total putto-call ratio rose to 1.00 (Table 10.4), the OEX put-to-call ratio fell to 0.75for the second day. Therefore, while the total put-to-call ratio was rising tosuggest that the majority of options traders were becoming bearish, theOEX ratio fell and signaled that the savvy traders in the S&P 100 Indexwere becoming more bullish. That, in turn, set the table for the October toDecember 2005 stock market rally.Instead of using the OEX ratio, some traders prefer to follow theCBOE Index put-to-call ratio, which is simply the CBOE put-to-call ratiominus equity option volume. Since there is almost always more index putactivity when compared to index call activity on the exchange, the indexput-to-call ratio stays above 1.00 most of the time. When it falls below1.00, it indicates that index traders are growing more bullish and indexcall activity is outpacing index put trading. When it rises above 2.00, theindicator tells us that index put activity is two times greater than call activity, demonstrating high levels of bearish sentiment.History has shown that, as with the OEX, index traders as a wholeare generally correct in predicting turning points. Therefore, the indexput-to-call ratio is not a reliable contrarian indicator. For that reason, itis often useful to filter it out. That is, consider the total put-to-call ratioand the equity-only ratio as contrary indicators, but use the index andOEX put-to-call ratios to get clues regarding what the smart money isdoing.
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ISEEOne of the newest and most useful sentiment tools, the International Securities Sentiment Index (ISEE) is used to track daily call and put activityon the International Securities Exchange (ISE). It is similar to the morewidely used put-to-call ratio, but with a twist. First, the ISEE measuresonly the trading activity on the International Securities Exchange, today’slargest stock options exchange.In addition, the formula for computing ISE Sentiment Index is different from the put-to-call ratio. The ISEE is computed as the day’s call activity divided by put activity multiplied by 100. Therefore, the ISEE will fallwhen bearish sentiment increases and rise when bullishness is high. Thisindex typically stays between 125 and 225.Another important difference between ISEE and the more widelyused put-to-call ratio is that the ISEE measures only call and putpurchases, rather than total volume. So the International Securities Exchange’s indicator improves on the put-to-call ratio by limitingthe analysis to puts and calls that have been bought throughoutthe trading day. Options that have been sold are not included in theequation.Despite a relatively short track record, the ISEE does a pretty goodjob of highlighting extreme levels of bullish or bearish sentiment. For instance, in December 2004, the index rose above 200 on 19 different occasions, which signaled that call purchases were outnumbering putpurchases more than two-thirds of the time during that month. This offered a sign that bullish sentiment was running too high and was unsustainable. That, in turn, signaled an end to the rally and a market declineduring the first quarter in 2005. Figure 10.8 shows the spike in the ISEE(10-day average) that occurred in December 2004.So, like the total put-to-call ratio, the ISEE is used as a contrarian indicator. In sum, consistent readings above 200 hint at market topping conditions. When the ISEE falls below 140, it is a sign that put purchases arerunning above normal and the market might be oversold.
Put Volume IndicatorJohn Bollinger, best known among option traders as the creator ofBollinger Bands, is the originator behind a unique sentiment indicatorknows as the Bollinger Put Volume Indicator (PVI). As the name suggests,this indicator measures relative levels of put activity. Similar to the put-tocall ratios, the indicator can be applied to an individual stock, a specific
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FIGURE 10.8 ISEE and S&P 500 Index
index like the S&P 100 ($OEX), or to an entire exchange. It is another contrarian indicator.Computing the PVI requires put option volume history. In this example, we use the total put volume on the CBOE. The daily put volumedata is readily available in the market statistics section of the exchange’s web site (www.cboe.com). From there, PVI is easy to compute. The indicator is equal to the current day’s put volume divided bythe 10-day moving average (MA) of put volume. If the ratio rises, it indicates that put volume and bearish sentiment are on the rise. For instance, a reading of 2.00 tells us that the day’s put volume, andtherefore bearish sentiment, is two times greater than average. Lowreadings indicate relatively high levels of bullishness or complacencyamong investors.The best way to use the PVI is to identify episodes of extreme pessimism or even panic. This often occurs at or near market bottoms andwhen investors are capitulating. Figure 10.9 shows two such recent spikesin the PVI (in August 2004 and April 2005). Both signals occurred withindays of market reversals.
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FIGURE 10.9 Bollinger’s Put Volume Indicator (PVI)
OTHER SENTIMENT INDICATORSIn addition to the put-to-call ratios and other data from the options market, a variety of other indicators can be used to gauge market sentiment.They will not always confirm each other, but the idea is to find when sentiment reaches extremes by having many indicators flashing the same signals. In other words, the best time to get aggressive with investments iswhen a number of indicators are confirming each other.
Investment SurveysSeveral services provide updates regarding investor sentiment from pollsor surveys. Investors Intelligence runs the most prominent one. Its surveylooks at sentiment of newsletter writers, and the bullish and bearish percents are reported weekly. For example, in December 2004, as stockswere reaching a peak, the survey reported that 61.2 percent of those surveyed were bullish and only 21.1 percent were bearish. The ratio of bulls
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to bears became extremely lopsided and that paved the way for the market decline. Market Vane, the American Association of Individual Investors (AAII), and Consensus, Inc (the Consensus Index) also conductregular surveys of prevailing investor attitudes.
Commitment of TradersThe Commodity Futures Trading Commission (CFTC) requires thattraders report positions after they reach certain reporting levels. This information is provided to the public in the Commitments of Traders (COT)report, which is released weekly. The most recent and historical COT reports can be found at the CFTC web site (www.cftc.gov). The CFTCbreaks traders down into three groups: small speculators, large speculators, and commercial hedgers. Large speculators are those that are holding certain position levels (i.e., more than 100 S&P 500 Index futurescontracts). Commercials are firms or businesses that deal with commodities as part of their normal course of business activity. The positions ofthe small traders are found by subtracting open interest in the other twogroups from the total open interest values.In looking for signs of shifting sentiment, it pays to follow the commercial traders because these are decisions by well-informed individualswho have a lot at stake. According to Alexander Elder, in his book Trading for a Living (New York: John Wiley & Sons, 1993), big speculators today are “trend following behemoths” and “do poorly as a group.”Furthermore, “The masses of small traders are proverbial ‘wrong-wayCorrigans’ of the markets.” In sum, it pays to play with the commercialsand against the speculators, big or small.
Short InterestShort interest is calculated each month by the exchanges and tells atrader how many shares are being shorted. Short stock occurs when atrader sells stock he does not own, expecting the stock to decline sothat he can then purchase the stock back at a lower price to cover theshort position. This is a bearish strategy, and option traders can benefitfrom this information. The short interest ratio tells us how many daysof normal volume it would take for all the short shares to be covered.The higher the number, the more the stock will move to the upsidewhen the shorts start to cover. Shorting stock leaves a trader in an unlimited risk position. Thus, as the stock starts to rise, those traders whoare short will quickly buy shares to limit their losses. As a result, themove to the upside accelerates and creates a rather large move in ashort amount of time.
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As an example, in August 2005 short interest hit record levels on theNYSE when 8.585 billions shares were sold short. When the marketstarted to rally, there was a lot of money to be lost by said sellers, whichemotionally forced them to buy back their shares. This action added significant fuel to the market’s gains. Additionally, the higher the marketgoes, the more short sellers have to buy to avoid further losses. Therefore,high levels of short interest on the NASDAQ and the NYSE are generallyconsidered bullish from a contrarian view. The following quote is an example of a short interest update.Short Interest Declines by 0.5% on the Nasdaq As IndexClimbs Over 3% Indicating Bulls Up AheadShort interest fell on the Nasdaq Stock Market for the latest monthlyreporting period, but still ended 2005 showing a sharp annual increase. Analysts attribute this year’s rise in short selling to lingering economic jitters and increased trading by hedge funds, whichoften use sophisticated strategies that involve both bullish and bearish bets.*
Mutual Fund FlowsThe mutual fund industry controls nearly $9 trillion in assets. As a result,the activity in the industry has an important bearing on the performanceof the financial markets. While mutual fund flows alone are not enough topush the stock market higher or lower, the flows do serve as an importantsource of liquidity.When inflows into stock funds are robust, it serves as an importantsource of buying demand for the market. According to the InvestmentCompany Institute (ICI), stock mutual funds hold $4.66 trillion in assets asof October 2005. By way of comparison, assets within stock ETFs totalless than $260 billion, according to the same statistics from ICI (availableat www.ici.org). Therefore, given the massive size of the mutual fund industry, the inflows and outflows can have important implications for thestock market.A number of services provide updates regarding mutual fund inflowand outflow. The ICI reports its statistics monthly. For instance, accordingto its November 29, 2005 report, “Stock funds posted an inflow of $6.45billion in October, compared with an inflow of $7.92 billion the monthbefore (Investment Company Institute—www.ici.org).
*Peter A. McKay, Wall Street Journal, December 28, 2005, page B7.
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AMG Data and TrimTabs Investment Research also provide updatesregarding equity fund inflows and outflows. Some of the information isfree while some requires a fee. The important thing from an index trader’sstandpoint is that heavy inflows into mutual funds have been a drivingforce for the stock market for decades. During times when the inflowsslow or even turn into outflows, market volatility invariably increases.
Mutual Fund Cash Assets PercentageOne reason for the increase in volatility during periods of equity outflowsis that portfolio managers put new money to work in the market and holdvery little cash. Since their jobs are on the line they have to beat the market, and holding cash won’t help their cause. Consequently, cash allocations at stock funds are anemic.According to ICI, the average mutual fund holds just 4.0 percent incash today. The chart in Figure 10.10 shows the 20-year trend in the cashasset allocation ratio. The current level of 4.0 percent remains near historical lows. This low ratio tells us that, as money moves into stock funds,managers are quickly using it to buy shares. However, the tables could
FIGURE 10.10 Mutual Fund Cash Assets Percentage (Source: Investment Company Institute)
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also turn in times of trouble. That is, if investors begin selling mutual fundshares, cash-strapped fund managers may be forced to aggressively sellstocks in order to raise cash. We see signs of this happening during thepanic selling in April 2000 and again in September 2001.
SEASONAL TRENDS AND INDICATORSSentiment indicators like the put-to-call ratio, the ISEE, and short interestare used to gauge the prevailing investor mood in order to help determinewhether the current bullish or bearish trend is likely to last. Next, we turnour attention to seasonal indicators. These are patterns that have developed over time and can help identify forthcoming periods of strength orweakness in the stock market.
Super Bowl IndicatorThe Super Bowl indicator is not one on which we base our trading decisions, but it is interesting because it has a great track record. In fact, it hasworked 31 out of 38 times. According to this indicator, if the team thatwins the big game is from the American Football League (now the American Football Conference, AFC) the bears will seize control of the market.However, if a National Football Conference (NFC) team wins, the marketwill move higher during that year.The indicator produced positive results for decades, as the NFC teamwon and the stock market moved higher. However, in 1998, the DenverBroncos of the AFC won, which was a cue to bet against the market. Bigmistake, because the S&P 500 rose 28 percent that year. The Broncos wonagain in 1999 and stocks moved higher again. When the NFC Rams won in2000, it was a positive omen for the stock market, but, alas, stock pricesfell anyway. Similarly, the Rams won again in 2001, but stocks tumbled.Super Bowl SummaryBullish YearsBears—198649ers—1982, 1985, 1989, 1995Colts—1971Cowboys—1972, 1993, 1994, 1996Giants—1987, 1991(Continued)
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Super Bowl Summary (Continued)Packers—1967, 1968, 1997Buccaneers—2003Redskins—1983, 1988, 1992Steelers—1975, 