INDEX INTELLIGENCE: Excessive Pessimism? Not Yet
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By Frederic Ruffy, Optionetics.com
1/31/2003 1:00:00 PM
With the recent slump in the market, many market watchers have duly noted the increase in bearish sentiment among investors. During the second half of January, while the Dow Jones Industrial Average ($INDU) has tumbled nearly 10%, the market’s “fear gauge” has risen from 26.6% to 36.4%. It appears that the recent concerns regarding war, along with earnings warnings, and signs that the fragile US economic recovery is faltering have all combined to drive up market angst. Some technical analysts view this growing concern or increasing anxiety among investors as a positive for the market. From a contrarian approach, these episodes of excessive panic and fear often set the table for market rallies. What is sometimes difficult to measure, however, is just how pessimistic investors have become. For that reason, in addition to looking at VIX, some analysts use other tools such as the CBOE put-to-call ratio.
The CBOE put-to-call ratio has been a reliable indicator through the years. Like other sentiment indicators, it is a window into the mass psychology of the market. It attempts to measure whether investors are predominantly fearful, pessimistic, and bearish or complacent, greedy, and bullish. When the ratio suggests that investors, or the crowd, have reached one extreme or another, it generally pays to bet against them.
The ratio is fairly easy to compute and interpret. CBOE stands for the Chicago Board Options Exchange, which is the world’s first and largest organized options exchange. The CBOE put-to-call ratio is computed as the total put volume divided by call volume on a daily basis. The numbers can be found each day at the Chicago Board Options Exchange’s website, cboe.com. Readings from the past seven days can also be found every Friday at the Optionetics.com home page in a weekly column known as Sentiment Journal [written by Frederic Ruffy – ed.].
When put volume rises relative to call volume, the CBOE put-to-call ratio will increase. Sometimes, put activity will surpass call activity. When this happens, analysts interpret it as a bullish indication for the market because growing levels of put activity is a sign of investor pessimism. For instance, the CBOE put/call ratio recorded one of its highest readings ever (1.26) on October 8, 1998. That date, of course, marked a major bottom for the stock market.
While high readings from the CBOE put-to-call ratio are a sign of increasing pessimism, low numbers often occur during periods of euphoria, greed, and bullishness—or the type of market psychology that generally prevails before stocks take a major tumble. Therefore, when call activity becomes extreme, the put/call ratio falls and that suggests that investors are becoming bullish. In that case, the contrarian will become cautious towards the market.
The ratio generally oscillates between .5 and 1.00 because there is almost always more call than put buying. When the CBOE put-to-call ratio rises above 1.00, it gives a bullish or “buy” signal. The last definitive signal from ratio occurred on January 27, 2003 when it rose to 1.02. The next day, the Dow Jones Industrial Average gained 100 points.
While the CBOE put-to-call ratio can sometimes produce short-term trading signals, it is more reliable when considered over time. For instance, Figure 1 is the ten-day average of the ratio. By averaging the readings over time, it eliminates bad signals from abnormal trading activity due to option expirations and low volume during holiday half-day trading sessions. Notice that the ratio spiked higher in September 2001, when the terrorist attacks of 9-11 created extreme levels of fear among investors in the stock market. Again, the ratio jumped higher in early-October 2002. Both of those high readings occurred near important market bottoms in the market.
Figure 1: Put/Call Ratio, CBOE
More recently, however, the CBOE put/call ratio has been falling. Today, the 10-day moving average reads .75, which is in neutral territory. It is certainly not giving definitive indications that investors are extremely bearish like in September 2001 and October 2002.
In addition, recent put volume has not been consistent with high levels of investor angst. Put activity generally increases during periods of intense market fear and mayhem. Figure 1, however, shows that put activity on the CBOE has been relatively light recently and nowhere near levels seen during other important market bottoms.
Figure 2: Put Volume, CBOE
In conclusion, many technical analysts look for signs that investor sentiment has become extremely negative, pessimistic, or bearish because most major market bottoms occur during such periods of market angst. Recently, due to concerns about Iraq, earnings, and the economy, stock prices have been falling and fear has been rising. However, some indicators—like the CBOE put-to-call ratio—can help measure pessimism relative to other market bottoms. Doing so reveals that, while investors have been growing more bearish, the negative psychology today has not yet approached the levels of pessimism that have existed during other important market troughs.
Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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Gottfried, when those newsletter writers express excessively bullishness or bearishness they are an excellent contrarian signal. It matters not whether they have actual fear or not what matters is that they are almost always wrong at the top or the bottom.
Lets not waste any more of our precious time. Instead lets discuss indicators that will help us determine the next bottom. Can you help me find a site where we can follow the PVI on a daily basis? I watch the ratio but not the volume indicator. Maybe this is the best we can do:
cboe.com
Thanks, RtS |
