Intermediate-Term Sentiment Indicators For Spotting Market Bottoms
My intermediate-term market view
starts and ends with the market itself. First comes the trading action of high relative strength
stocks (the waters I fish in). Then I
look at the major averages and market volume. Everything else is secondary. I
act only when evidence comes in strong from top-performing stocks and the
Dow or the Naz.
With that preamble, I still find
other, secondary indicators useful in judging market climate. I take monetary
conditions into serious consideration. Among other monetary gauges, I keep
a weather eye
on the yield curve, quality yield spreads and the fed
funds futures. During correctional or bear markets, I use options
volume to flag the kind of panic selling that can form durable
bottoms, setting the stage for a fresh rally.
As an intermediate-term momentum
trader, I trade with the trend. However, all trends end. Often, the end comes
after the trend becomes too obvious. A rally hyper-accelerates as greed whips
the crowd into a buying frenzy. Once demand becomes exhausted, the downside
reversal ensues. In like fashion, a correction hyper-accelerates as
shareholders at last give way to fear. A capitulation sell-off occurs, then the
market reverses to the upside.Â
To detect market turns, I look first
to the behavior of individual stocks and the broad averages. But psychological
indicators such as those based on options activity can throw confirming light on
a situation. If they register the extreme levels of greed or fear consistent with
peaking or bottoming action on the indexes, I probably will feel reinforced in
my read of the market’s message and act more deliberately. If my secondary
indicators contradict my primary indicators or render an inconclusive signal, I
might still proceed based on my primary indicators. However, I may have less
confidence in my market assessment, so I may proceed less aggressively on that
assessment. Â
Like many other traders, I have found
sentiment gauges to be more useful in spotting bottoms than tops. Fear is a more
powerful emotion than greed. As a result, bear markets typically conclude in
sharp, explosive sell-offs, characterized by dramatic expansions in daily range
on the indexes and in market volume. On the other hand, general market tops often
form gradually. In some tops, the averages roll over slowly, ponderously, like
an oil tanker changing course. You’re more likely to see sharp, violent tops in
high-momentum industry groups. For more on this trading action, see my lesson on climax
tops.
To form a durable bottom, a correction or outright bear
should climax in a capitulation sell-off. The idea here is that the weak
holders, shareholders with paper losses, panic and throw away their shares at fire sale
prices. In the turnover, a fresh class of bulls buys stock with both hands. The
best sign of this would be sharp decline in the major indexes followed by
intraday or next day recovery, on powerful market volume.
Consistent with such sell-offs is a
steep increase in put option volume. Most
traders look at put activity in comparison to call option activity. This is most
often done by dividing put volume by call volume, yielding a put/call
ratio.Â
The idea behind using option activity
to spot a bottoms is pretty straightforward. Option buyers are regarded as
speculators. Speculators, as a crowd, tend to be wrong at market extremes. Buying a put is a
bearish play. It confers upon the owner the right, but not the obligation, to
sell the underlying security at a specified price. So the put buyer stands to
benefit from a price decline in the underlying security. So an extraordinary surge in put volume can flag excessive bearishness the prevails at a bottom. (Buying a call is a bullish
play. It confers upon the owner the right, but not the obligation, to buy the
underlying security at a specified price.)
You can use any number of tools for
measuring sentiment with puts and calls. I look at total options volume on the Chicago
Board Options Exchange. That means that I am looking at the combined
index and equities options activity. I like to see both a big surge in raw put
volume as well a spike in the put/call ratio above 1.1 on a closing basis. Other traders like to
use just put and call options on individual stocks on the CBOE. Hedge fund
manager Greg Kuhn, who trades intermediate term, often refers to a 15-day CBOE
equity-only put/call ratio. John Bollinger, a money manager and technical
innovator, has developed a bottom-flagging signal that compares equity and index
put volume on the CBOE to its 10-day moving average.Â
The CBOE publishes a breakdown of
option volume as well as a put/call ratio based on total options activity in its market
statistics summary on the Web. The page provides historical data as
well as stats from the last close.Â
There are several points to bear in
mind.Â
1. As I pointed out, successful
traders use a variety of put or put/call gauges in their sentiment work. The key
is to familiarize yourself with your chosen indicators behavior during trending
and reversal phases of the stock market.
2. No signal is 100% accurate. An
indicator with
50% accuracy would be a strong signal. Put/call signals, used alone, are
weaker still. Never try to time the market entries or exits based exclusively on
options volume or ratios.
3. Intermediate-term momentum traders
should take the market at its word. That means looking first to the trading
action high-performance stocks, general market volume and broad indexes. In my
own work, a strong consensus from those primary signals probably will trump a
contradictory signal from weaker secondary indicators like put/call ratios.
However, a contradictory signal from a secondary indicator might be cause to be
on my guard. I’ll show an example shortly.
The last clear bottom signal from the
put/call ratio came on Oct. 8, 1998. The Nasdaq Composite tumbled 8.1% to an
intraday low of 1343.87 before paring its losses to close at 1419.12, off only
3.0% and closing in the upper half of the day’s session on huge volume. The
S&P 500 fell 4.9% to an intraday low of 923.32 before paring losses to close
at 959.44, off 1.1% and in upper quarter of the day’s range.
Coinciding with the Oct. 8 reversals
were extreme fear readings in the options markets. Equity and index put volume
swelled 65% to 742,413 contracts on the CBOE from 448,811 contracts on the prior session.
The put/call ratio rose to 1.27 from 0.94. In hindsight, we know the Oct. 8 session formed the
trough of the summer 1998 bear market and the beginning of the subsequent
bull market.
As I said before, I will not buy into
a bottom until confirmed by subsequent tape action — preferably in the form of
an O’Neil follow-through day — and a growing number of high RS stocks setting
up in proper bases and breaking out.
I don’t need panic sentiment readings
to re-enter the market after an apparent reversal following a bear market
provided the follow-through day occurs along with breakouts by high RS stocks.
However, recent history suggests that the absence of capitulation signals from
the options gauges is reason to the follow-through day a bit more cautiously.
The FTD is one of the best signals that a prior reversal has given rise to at
least a tradable rally. But as I said before, no signal is 100% reliable.
For example, the market delivered a
follow-through day on June 2, 2000 on the Naz subsequent to a reversal off its
then-low of 3042.66 on May 24. The May 24 session had a number of qualities for
a good reversal. Heavy volume, intraday reversal off a new low of the bear
market, a close at the top of the day’s range. However, while bearish put and
put/call activity expanded, it did not register the rampant fear that was so
convincing, for example, in the Oct. 8, 1998 precedent.Â
The FTD was good for a few trades.
There were valid, profitable breakouts during this phase. But this was not the
kind of full-bore rally awaited by the intermediate-term trader. The
rally-within-a-larger-bear-market peaked on July 17, then rolled over. So again,
the lesson I would take from this is as follows: I would still trade the
follow-through day if I got breakouts in high RS stocks, even with unconvincing
negative sentiment readings on the earlier reversal day. But I’d probably be
less aggressive in the initial rally phase than would be the case if the
reversal day registered powerful negative sentiment.
For the similar reasons, traders
should treat the current bounce off the Nasdaq Composite’s Nov. 30 low with
skepticism. If the rally produces a follow-through day and high RS stocks set up
and breakout, I would trade it. But I’d probably be less aggressive than if the
Nov. 30 low had coincided with high fear readings on the put/call ratio.
The following chart shows the Nasdaq
Composite and CBOE put/call ratio through Dec. 1. Note that while the Naz headed
south over the past three weeks, the put/call ratio actually declined. Instead
of falling prey to panic and bailing, speculators have grown more bullish! On
Nov. 30, the put/call ratio actually fell to 0.75. This is the exact opposite of
what one wants to see in the formation of a bottom.
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