Tips on Technicals - Sentiment Indicators
In any market, whether financial, commercial or consumer, prices are set when supply and demand are in equilibrium. No matter what a favorite technical indicator or fundamental report might say, prices will not move unless the relationship between supply and demand changes. Since individuals' beliefs of fair value are based on expectations of the future, prices at which they are willing to trade change with the prevailing mood in the market. This chapter will explore how market expectations can be used to make trading decisions.
Measuring Expectations that Drive Markets
Sentiment is the term used for the summation of all market expectations. It ranges from fear and hopelessness to indifference to greed and complacency. At the bottom of a bear market, the expectations of market participants are almost unanimous for lower prices and more financial losses. As a rally begins, some of these participants become hopeful and prices rise off their worst levels. In the middle of the bull market, many players have changed their expectations but not everyone is bullish.
Near the end of the rally, almost everyone is assuming that the trend will continue. More risks are taken and greed becomes dominant. In other words, market sentiment is at a high. When this happens there is nobody left to buy more. Prices can no longer rise since everyone has already bought.
There are many quantifiable technical measurements of market sentiment. They range from comparisons of small vs. large players, strong money vs. weak money and even the tone of magazine cover stories. All are based on the premise that the majority is usually wrong at the extremes. Again, in a rising market, this is because the majority has already bought so there is nobody left to buy more. Demand has dried up and prices must fall.
The following are just a few of the more popular methods used to gauge sentiment:
Put/Call Ratio - The more people that take the bet that the market will drop (by buying puts), the larger the majority. Conversely, high call buying means the majority is betting on a rally. In both cases, the market goes against the crowd. Options volume is usually used in a ratio but can be skewed by options strategies. Open interest by type, strike and expiration provides a more accurate indication of the financial commitment of traders.
Short Interest - This one is limited to stocks only but is essentially the same as the put/call ratio. The more short interest, the more people are expecting lower prices and the more likely the market will rise.
Commercial Activity - In the commodities markets, commercial players such as gold mining companies, grain processors and oil companies command a very large share of trading volume. These are the hedgers seeking to lay off risk onto the speculators in order to lock in prices. When commercials buy or sell, it is based on insider knowledge of the market and is an excellent indication of general market expectations. In the US, the weekly net commitment of traders report isolates who is trading what. It also breaks down large traders vs. small traders.
The Media - Major market turning points often follow high exposure news reports. This is because these stories are only newsworthy when the trend is widely accepted and a majority opinion is formed. Financial markets generally turn shortly thereafter.
There are many others, such as mutual fund redemptions and margin debt levels, but the key is that each measures how much risk market participants are willing to take to match their fear and greed opinions. The higher the degree of speculation, the higher the expectation and the more likely will be a lack of new buyers -- everyone has already bought.
The Contrarian Approach
Contrarians use extremes of sentiment to forecast market turns. Low expectations, whether at low or at high prices, signal that the market is likely to rise. Conversely, high expectations, whether at low or high prices, signal that the market is likely to fall. Anything in the middle signals the continuation of the current trend.
The charts show the S&P 500 and the Cboe volatility index (VIX). The VIX is based on the implied volatility of the very active OEX (S&P 100) options series and indicates how much people are willing to pay for options. All options are priced higher when volatility rises.
When the stock market fell sharply in July 1996, the index shot up. This indicated that people were paying any price to buy downside protection. The fear of lower prices was extreme. This low expectation coincided with the market bottom and stocks went on to set new highs.1
Sentiment is a valuable tool to have when forecasting the markets. However, like most other tools, it should not be used alone. This is true for all non-indexed indicators because the question "how high is high" applies. Only when the market begins to react to extremes of expectations by reversing direction should the contrarian step in to trade.
1 A spike in VIX during rallies indicates greed as people pay up for call options.
