A.
OPTION VOLUME INDICATORS
By definition, participants in the options markets are making short term judgments, trading judgments. Even though they may be using options to augment a longer term strategy, the limited life of an options contract (most of the activity in the options market is in contracts that are just two or three months from expiration) means most participants are making some kind of a short term decision when they buy or sell a call or a put. I recognize that option activity includes hedging trades and not just directional trades, so the
movement of put/call ratios is not just a function of market psychology. Nevertheless, on the margin, I believe shifts in put/call ratios should have a distinct sentiment component. If option traders are becoming bearish, they would be expected to be more interested in puts than calls. If option traders are becoming bullish, they would be expected to be more interested in calls than puts. That appears to be the case. Put volume increases relative to call volume when trend-motivated option traders grow more bearish and put volume decreases relative call volume when option traders grow more bullish. Under my assumption that short-term-oriented equity market participants are likely to be overly bearish near lows of consequence and overly bullish near highs of consequence, put/call volume ratios should often be found high near bottoms and low near tops.31 In other words, puts garner more attention “too late” in declines and calls garner more attention “too late” in advances. Remember, this is not to say options participants cannot be successful; as a group they can be successful most of the time. However, their trend-
motivated activities results in “too much” bullishness near tops and “too much” bearishness near bottoms. Much of the activity in the options markets is professional; professionals succeed by getting back on the right side quickly.
The four put/call option volume charts below have necessarily limited history since they are daily charts; they start at the beginning of 2011 and end in the third quarter of 2013. Earlier data is similar. I have drawn bull lines one standard deviation above one-year averages and bear lines one standard deviation below one-year averages to give some approximation of high and low levels, not because any particular level is a clear buy or sell signal. The indicators should be used to increase or decrease confidence in the trend outlook, not to anticipate imminent reversals. The charts are 10-day moving averages, plotted along with the S&P 500. The four charts are equity options (opening transactions only) on the ISE exchange (www.ise.com/market-data/isee-index), index options (opening transactions only) on the ISE exchange, equity options (all transactions) on the CBOE
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exchange (www.cboe.com/data/mktstat.aspx), and index options (all transactions) on the CBOE. I have excluded the trading in VIX options since it can be argued that buying VIX calls is a bearish bet, not a bullish bet. Note that even though the ISE data are just open-buy- puts divided by open-buy-calls and the CBOE data also include sell-to-open calls and sell-to- open puts, the ratios are similar. The charts show that put/call ratios usually spike near bottoms, bullish readings, implying the option participants are very negative. The ratios are usually in the neutral-to-low regions during advances (i.e., the option participants are getting the uptrend message correctly). The combination of low ratios and faltering price action are bearish readings. Chart 19 below, the ISE 10-day Index Put/Call Ratio, gives the least useful information, although the mid September 2012 very low reading occurred at the inception of a two-month market correction. The very high readings in mid July 2011 and in the first half of July in 2013 were not helpful.
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Chart 20 below, the ISE 10-Day Equity Put/Call ratio, was quite helpful, with all the very high readings occurring near important or interim market bottoms. The sustained high readings from mid August 2011 through late November 2011 coincided with the
intermediate bottom in the market in 2011. The sustained very high readings between mid May 2012 and mid June 2012, and between late June 2013 and early July 2013 coincided with interim market setbacks.
Chart 21 below, the CBOE 10-Day Index Put/Call Ratio, shows two clear, sustained high readings, late August 2011, at the beginning of the market basing pattern that year, and in the second half of May 2012, at the end of an interim correction. Once again, I find low index put/call ratios near interim tops, such as mid March 2012 and mid May 2013, but also in the second week of August 2012 (the middle of an upleg) and in mid December 2011 (early in an upleg).
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Chart 22 below, the CBOE 10-Day Equity Put/Call Ratio, shows sustained high readings three times, mid June 2011 (an interim low, albeit close to a medium term market top), mid August 2011, at the beginning of a medium term market base, and the third week of May 2012, at an interim market bottom. There are low readings in late March 2012, in the third week of September 2012, an in late May 2013, all near the beginning of interim market tops. There are a series of low or relatively low readings between mid October and mid December 2013, all near minor tops, but no high readings near the interim minor bottoms in that period.
I tested the put/call ratios, regressing 10-day returns for the S&P 500 on the 10-day averages for each of the four ratios, the using the Newey West (1987) procedure. The equation is:
𝑅𝑒𝑡𝑢𝑟𝑛𝑡 = 𝛼 + 𝛽1𝑃𝑢𝑡𝐶𝑎𝑙𝑙𝑅𝑎𝑡𝑖𝑜𝑀𝐴𝑡−10+ 𝜀𝑡
As I expected the equity ratios showed much better results than the index ratios (which I attribute to much hedging activity in the index options and little hedging in the equity
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higher next 10-day returns. For the CBOE equity put/call ratio, the coefficient is positive (0.045) and significant (p = 0.025), and the R-squared is higher than the index put/call ratio (0.0135, compared to 0.003). The results were similar for the ISE ratios.
A separation of the data into four quartiles by levels of the put/call ratios also showed useful results. Low put/call ratios led to low returns and high put/call ratios led to high returns. See appendix 4.
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B.
OPTION PREMIUM INDICATORS
Option premium indicators are analogous to option volume indicators. I noted above that if options traders are bearish, put volume is expected to increase relative to call volume, and if option traders are bullish, call volume is expected to increase relative to put volume, and the data show both do occur. Likewise, traders should be expected to pay relatively more for puts than calls when they grow bearish and they should be expected to pay relatively less for puts than calls when they grow bullish. Put/call premium ratios should move similarly to put/call volume ratios, and they do. For those comparisons, I use the weekly option premium data from the Options Clearing Corporation (OCC)
(www.optionsclearing.com/webapps/weekly-volume-reports). The OCC provides a put/call premium ratio for the equity options and a put/call premium ratio for the index options. Charts 23 and 24 below show 4-week averages of the put/call premium ratios compared to the S&P 500. I have drawn bull lines one standard deviation above the 10-year average of the put/call ratios and bear lines one standard deviation below the 10-year averages. Chart 23 below, the equity premium ratio, shows several spikes in the 4-week average during the 2000-2002 equity bear market near interim lows. Very high readings were recorded several times during the late 2002-early 2003 basing period and again at the beginning of the late 2008-early 2009 basing period. Readings were expectably low during the steady market advance from the 2009 lows through 2013, although there was one increase to very high readings in late June-early July 2013, associated with the end of a temporary market correction. Chart 24 below, the index premium ratio, is similar, but gives an even clearer message. It shows spikes to high levels near interim lows during the 2000-2002 equity bear market (and one at a temporary low during the 1999 topping process) and near the lows of temporary setbacks in the post 2009 bull market. The highest readings, the very high sustained ratios were registered during the major bases in late 2002-early 2003 and late 2008-early 2009.
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C.
SENTIMENT POLLS
All of the indicators I have discussed above are “transactional” indicators, indicators that measure what investors and traders are doing in the market place. There is another class of sentiment indicators, surveys of equity participants, polls that measure what those
participants are saying about the equity market. As it turns out, all the polls are surveys of equity market participants with short term time horizons. Based on my assumption that short-term-oriented equity market participants, traders, are likely to be wrong at turning points, I would expect the polls to show excessive pessimism at market bottoms and excessive optimism at tops. And they usually do. I will discuss four polls that are widely followed in the financial media: the poll of stock index futures traders conducted by
Consensus, Inc., the poll of stock index futures traders conducted by Market Vane, the poll of market letter writers conducted by Investors Intelligence, and the poll of investment club participants conducted by the American Association of Individual Investors.32
Consensus, Inc. and Market Vane, both polls of futures traders, have a slightly different methodology so the readings are usually slightly different. Both surveys are polls of professionals, but Market Vane weights the readings by its opinion of the impact of the pollee, while Consensus, Inc. gives equal weight. Notably, both surveys are polls of
professional traders, people who make their living trading stock index futures; nevertheless, they both show “excessive” optimism at market peaks and “excessive” pessimism at market troughs. Each week the services poll the traders and report the percentage of bulls. In the last 10 years Consensus, Inc. reports an average bull reading of 55.2%, with one standard deviation of 15.5%, and Market Vane reports an average bull reading of 58.4%, with one standard deviation of 9.9%. The Consensus, Inc. data in Chart 25 below shows a four-week M.A. of the bullish percentage, with a bullish line drawn in one standard deviation below the 10-year average and a bearish line drawn in one standard deviation above the 10-year average, compared to the S&P 500. As I would expect, weak markets (and, therefore, market lowpoints) are characterized by little optimism and strong markets (and, therefore, market highpoints) are characterized by great optimism. After the major stock market top in 2007, the indicator reached extremely low (i.e., bullish) levels as early as the end of January 2008 and remained at or near such levels throughout the 2007-2009 bear market. The absolute lowest reading of 20.3% was registered a week after the final market low was reached in March 2009. Expectably, the indicator has been neutral most of the time during the post 2009 bull market, with all but one of the “excessively optimistic” readings leading to consolidations or interim setbacks, including October-November 2009, April-May 2010, January-May 2011, mid January-mid May 2012, and September-October 2012. The
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exception was mid February-mid June 2013, during which the market zigzagged higher. Interestingly, the only fully bullish (i.e., excessively pessimistic”) reading during the post 2009 bull market was after the biggest correction in that bull market, late August-late October 2011.
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As noted above, the Market Vane readings have been far less volatile in recent years, although they have a similar pattern to Consensus, Inc. Chart 26 below shows that the Market Vane bullish percentage reached its most negative levels during the 2006-2007 major equity market top, remaining at “excessively optimistic” levels from October 2006 through June 2007. It did not reach bullish (i.e., ‘excessively pessimistic”) during the 2007- 2009 bear market, but its lowest reading was 34% right at the bottom in March 2009, very near the bullish band, which stood at 33% at the market bottom. This indicator has been neutral all the time during the post 2009 bull market, with a brief bearish exception, 1% above the bearish band in the spring of 2013.
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The oldest of the popular sentiment polls is the survey of market letter writers conducted by Investors Intelligence. For over 50 years Investors Intelligence has been reviewing market letters weekly and assigning a bull or bear or neutral opinion rating to each comment and a giving aggregate figures. I have constructed a four-week average of the ratio of bulls to bears; it is shown below in Chart 27, compared to the S&P 500. The bearish line is drawn one standard deviation above the 10-year average bull/bear ratio and the bullish line is drawn one standard deviation below the 10-year average. I call readings outside the bands “extreme” or “excessive”. This indicator is popular because of its long, readily available record (it was carried in Barrons for most of its history) and because it has often been a contrary indicator. For example, Chart 27 below shows extreme pessimism (i.e., a bullish reading) during the market basing patterns in late 2002-early 2003 and late 2008-early 2009. Most letter writers claim to be giving long term advice, but clearly they are very influenced by short term moves in the market. The chart shows that as the market started up from those two bases, letter writers quickly became more optimistic, typical of short term traders. The charts do show extreme optimism at the 2000 and 2007 tops, but they also show periods of great optimism prior to interim setbacks during the 2003-2007 and post 2009 bull markets. Hence, no “formula” is going to provide a clearly profitable trading rule. Nevertheless, I believe this indicator can be used like other sentiment indicators, to increase or decrease confidence in a trend interpretation. In other words, when excessive optimism appears after an advance, look for a setback. If the ratio drops quickly back to levels of extreme pessimism, it probably means the setback was a minor, temporary affair. Such was the case in the summer of 2010 and in the fall of 2011. The opposite is also true. When excessive pessimism appears after a decline, look for a
rebound. If the ratio rises quickly back to levels of extreme optimism, it probably means the rally is a minor, temporary affair. Such was the case in July 2001, in January 2002, and in April-May 2002.
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The final poll is the survey of investment club participants conducted by the
American Association of Individual Investors (AAII). The AAII surveys investment clubs weekly and tallies the number of bulls, bears, and neutral. The poll is “flawed” compared to the other three polls above, because the list of pollees is not the same every week.
Nevertheless, since the results are similar to the other polls and because of the accessibility of the data (it appears in Barrons every week), I include it in this paper. Chart 28 below shows a four-week moving average of the bull/bear ratio compared to the S&P 500. The bearish line is one standard deviation above the 10-year average and the bullish line is one standard deviation below the 10-year average. The results are comparable to the other polls with one exception. It is true that the most sustained negative readings (i.e., excessive optimism) were recorded around the 2000 major stock market top and sustained positive readings (i.e., excessive pessimism) were recorded at the major bottoms in late 2002-early 2003 and late 2008-early 2009, and the indicator did not reach levels of extreme pessimism (falsely) during the 2000-2002 bear market. However, this indicator did not give a negative signal (i.e., did not register extreme optimism) at the 2007 major equity market top.
To test the series, I organized the 1987-2014 weekly data by deciles for both the percent of bulls and the percent of bears. The top decile of bulls and the bottom decile of bears were considered “excessive optimism”. The bottom decile of bulls and the top decile of bears were considered “excessive pessimism”. I tested short term periods (1, 2, 4, and 8 weeks) and, with some overlap, intermediate term periods (1, 2, 3, and 6 months). The results were favorable for both bullish and bearish signals in the intermediate term horizon and favorable for the bullish signals in the short term horizon. Only the bearish signals in the short term horizon showed unfavorable results. The best results were for bullish crossovers in the intermediate term horizon, with 80% of the signals registering positive results, for a cumulative gain of 459% in the whole time period. If a few anomalous
readings in August-October 1987 are disincluded, the short term bearish signals would have been much better. Those results were in line with my expectations: I believe bottoms form quickly and tops are drawn out.
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