A Fresh Look at Stock Market Psychology

My blog has recently begun an investigation into the value of equity put and call options as sentiment measures. I've developed a different way of viewing the options data, by looking at put volume and call volume as separate indicators. The resulting measures appear to do a nice job of predicting returns in the S&P 500 Index over a two-week horizon.

In my look at the options data, I am focusing on the relative elevation of put and call activity in the market. Thus, we have a high equity call ratio when the day's call volume is above its own 100-day moving average. We have a high equity put ratio when the day's put volume is above its own 100-day moving average. By viewing calls and puts individually, we can parcel out the impact of each upon the market.

In this investigation, I'm focusing on daily periods in which we have *both* a high equity call ratio and a high equity put ratio. What this is assessing is an elevation in total speculative activity among options traders. After all, the traditional put/call ratio can be 1.0 because both puts and calls are trading low volume or because they are both trading high volume. We lose information when we focus on the ratio rather than the components.

It turns out that, since 2004, we've had 86 instances of an equity call ratio above 1.2 *and* an equity put ratio above 1.2. Twenty days later, the S&P 500 Index (SPY) was up by an average of 1.19% (64 up, 22 down). That is quite a bullish edge relative to the remainder of the 2004-2006 sample, which showed an average 20-day gain of .54% (395 up, 239 down).

When both put and call volumes are elevated, we have significant differences of opinions among bulls and bears. In a sense, we can view that as a proxy measure for market uncertainty. When this uncertainty is high, stocks appear to yield superior returns over the following month. Combining this measure with the VIX--a measure of volatility priced into options--might provide an interesting options-based view of stock market psychology.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. His book, Enhancing Trader Performance, was recently released for publication (Wiley).