Sentiment Indicators:
Tuesday, June 16, 1998
Options
Tools to measure the mood
By RICHARD CROFT
For the Financial Post
ÿMany investors rely on so-called sentiment indicators.
These are tools that can help gauge the mood of
the market and to confirm other technical buy
and sell signals.
ÿThere are many such sentiment indicators,
including the once popular short-interest ratio.
The short-interest ratio measured the number of
shares sold short (those sold with the intent of
buying them back at a lower price) measured
against the number of shares outstanding on
the New York Stock Exchange.
ÿA high short-interest ratio was a measure of
pent-up buying power. Investors who sold
stock short would have to eventually buy it
back to close out their position. Theoretically,
if the market began to rise, the shorts would
panic and buy in, adding more fuel to the
upward movement.
ÿThe short-interest numbers were generally
viewed as a contrarian indicator. This meant
you would buy when other individual investors
were selling (that is, shorting). But a low short-interest
number was never that good in helping investors
determine when to sell.
ÿThis measure became so popular that
technical analysts created a short-interest
number for individual investors and another
for specialists (the professional traders
who work on the NYSE trading floor). You
wanted to be on the same side of the track as
the specialists. If the specialists were shorting
stock in a big way, then you wanted to take a
bearish view of the market.
ÿIn the end, the short-interest ratio was a victim
of its own success. If too many investors are
following a particular indicator, the indicator
doesn't work anymore. And to be fair, the
short-interest number hasn't worked particularly
well since the advent of exchange-traded options.
ÿRemember, the idea behind the high short-interest
ratio was investors had to buy in to their short
positions to cut their losses. But that assumed
their short positions were not hedged.
ÿToday, most short positions are hedged
with an offsetting option position, so there is
no urgency to close out when the market
begins to rise. That leads one to wonder
where all the bent up buying power has gone.
ÿThere are a couple of sentiment indicators
used by option traders: the put-call ratio and
the volatility index. The former is the option
market's answer to the short-interest numbers;
the latter is an excellent tool for providing a
confirmation at market tops and bottoms.
This week, we'll examine the put-call ratio.
ÿThe put-call ratio is simply the number of
puts divided by the number of calls traded
on any given day. A high ratio indicates that
more puts than calls have traded on that day; a
low ratio means that more calls than puts have traded.
ÿThe idea is to look for extremes in the measure. To measure extremes, you need to compare the daily put-call ratio with some moving average.
ÿThere are two widely followed put-call ratios. The
first is the put-call ratio on the Standard & Poor's
100 index options (symbol OEX), the so-called
index put-call ratio. By far, the OEX is the most
active option contract. On any given day, trading
in the OEX equals half the trading volume on
the Chicago Board Options Exchange. In fact,
daily OEX volume often equals half the volume
of all other options combined.
ÿBecause the OEX is so popular among
option traders, it provides a good proxy for
the mood of the market, particularly among
individual investors. The consensus view is
that most individuals trade OEX options
while most institutional investors use the
S&P 500 index options.
ÿThe second widely followed ratio is the equity
only put-call ratio. In this case, you calculate
the put-call ratio on all stock options that trade
on a given day on the CBOE. There is no
running total for equity only volume, only the
volume numbers for each index and the
total volume are calculated. To arrive at
the equity only volume, you need to do is
take the total put and call volume and s
ubtract the index call and put volume.
ÿYou don't need to subtract the put-call
volume from all the index options, only
the most active.
ÿThe four most active index options are the
OEX, the S&P 500 index, the Nasdaq 100
index and the Dow Jones industrial average
. Options on all four of these indexes trade
on the CBOE, and daily volume numbers
can be found at the CBOE web site (www.cboe.com).
ÿTechnicians use the put-call ratio
as a contrarian indicator, believing that
when too many individual investors are
bearish and buying puts, the market is
about to bottom. Similarly, when too many
individual investors are bullish and buying
calls, the market is about to make a short-
to medium-term top.
ÿThe idea is to buy the market if the put-call
ratio gets too high, and short the market if the
put-call ratio gets too low. The question is
how high is too high and how low is too low.
That's where the moving averages come in.
The idea is to smooth out the daily put-call ratio with,
say, a 10-day moving average. Too high is when
the put-call ratio is twice the 10-day moving
average; too low is when the put-call ratio is
half the 10-day moving average.
ÿThe put-call ratio is an excellent tool to help
gauge the mood of investors. However, it is
also a widely followed indicator, which has
hindered its effectiveness in recent years.
ÿThat's why you want to confirm a high index
put-call ratio with a high equity only put-call ratio,
in which case you would buy the market. If you
have a low index put-call ratio confirmed with
a low equity only put-call ratio, then sell the market.
ÿThe volatility index (symbol VIX) can also confirm
the put-call ratio, by helping gauge what investors
are willing to pay for an option at a point in time.
We'll talk about VIX next week.
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