While most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of their value as predictive tools. By tracking the daily and weekly volume of puts and calls in the U. While a volume of too many put buyers usually signals that a market bottom is nearby, too many call buyers typically indicates a market top is in the making.
The bear market of , however, has changed the critical threshold values for this indicator. Betting Against the "Crowd" It is widely known that options traders, especially option buyers, are not the most successful traders. Although there are certainly some traders who do well, would it not make sense to trade against the positions of option traders since most of them have such a bleak record?
After all, the options crowd is usually wrong. I can remember late and early into the new millennium, when option buyers were in a frenzy, buying up truckloads of call options on tech stocks and other momentum plays. And sure enough, with call-relative-to-put buying volume at extreme highs, the market rolled over and began its ugly descent. As often happens when the market gets too bullish or too bearish , conditions become ripe for a reversal. Unfortunately, the crowd is too caught up in the feeding frenzy to notice.
When most of the potential buyers are "in" the market, we typically have a situation where the potential for new buyers hits a limit; meanwhile, we have lots of potential sellers ready to step up and take profit or simply exit the market because their views have changed.
The chart shows the data for the put and call volumes for equity, index and total options. As you will see below, we need to know past values of these ratios in order to determine our sentiment extremes. We will also smooth the data into moving averages for easy interpretation. By total, we mean the weekly total of the volumes of puts and calls of equity and index options.
We simply take all the puts traded for the previous week and divide by the weekly total of calls traded. When the ratio of put-to-call volume gets too high meaning more puts traded relative to calls the market is ready for a reversal to the upside and has typically been in a bearish decline. And when the ratio gets too low meaning more calls traded relative to puts , the market is ready for a reversal to the downside as was the case in early Figure 2, where we can see the extremes over the past five years, shows this measure on a weekly basis, including its smoothed four-week exponential moving average.
Figure 2 reveals that the ratio's four-week exponential moving average top plot gave excellent warning signals when market reversals were nearby. While never exact and often a bit early, the levels should nevertheless be a signal of a change in the market's intermediate term trend.
It is always good to get a price confirmation before concluding that a market bottom or top has been registered. These threshold levels have remained relatively range-bound over the past 20 years, as can be seen from figure 2, but there is some noticeable drifting trend to the series, first downward during mids bull market and then upward beginning with the bear market.
More elaborate mathematical massaging of the data i. As the bear market has shifted the average ratio to a higher range, the horizontal red lines are the new sentiment extremes. The past range, indicated by the horizontal blue lines, had threshold values of 0. The new threshold values are 0. Currently, the levels have just retreated from excessive bearishness and are thus moderately bullish.
Conclusion Index options historically have a skew toward more put buying. Recall that the idea of contrarian sentiment analysis is to measure the pulse of the speculative option crowd, who are wrong more than they are right.
We should therefore be looking at the equity-only ratio for a purer measure of the speculative trader. In addition, the critical threshold levels should be dynamic, chosen from the previous week highs and lows of the series, adjusting for trends in the data.
As with any indicators, they work best when you get to know them and track them yourself. They should thus be included in any market technician's analytical toolbox. After years of debate, options have changed.
Find out what you need to know in Understanding The Options Symbology. Dictionary Term Of The Day. Broker Reviews Find the best broker for your trading or investing needs See Reviews.
Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Daily options volume for May 17, Source: Created using Metastock Professional. Pinnacle IDX Figure 2 reveals that the ratio's four-week exponential moving average top plot gave excellent warning signals when market reversals were nearby.
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