Market Sentiment Analysis
One of the many steps in trading is having a pulse on the markets, or at the very least having a pulse on the stock you are about to trade.
Having the pulse, or being in the know, or having an ear to the ground, or however you might want to say it is what we refer to as market sentiment.
Investopedia.
com defines it like this: "What Does Market Sentiment Mean? The feeling or tone of a market (i.
e.
crowd psychology).
It is shown by the activity and price movement of securities.
For example, rising prices would indicate a bullish market sentiment.
A bearish market sentiment would be indicated by falling prices.
" Most people believe that gauging market sentiment is as easy as turning on CNBC and listening to the talking heads in the morning, or watching Jim Cramer's Mad Money show to see how he feels about what's currently going on in the markets.
While neither thing is necessarily bad, there is a lot more that goes into gauging market sentiment than just one person's opinion.
No one news show or financial talking head should ever be taken as the all knowing soothsayer in what the markets will or will not do.
Market sentiment goes a little beyond simple rising or falling stock prices.
It is also about trying to predict as accurately as possible what direction the market is more likely to move in the future, near and far term.
Always remember, "more likely", not absolutely! Market sentiment can be gauged in a variety of ways: 1) put/call ratios 2) VIX 3) technical indicators 4) news and general market conditions 5) common sense.
1.
Put/Call Ratios Put/call ratios are simply the number of puts being bought vs.
the number of calls being bought on the same stock or index in the same month of expiration.
It can be measured in short or long term expectations.
It gives an investor an idea of what the rest of the market is thinking.
If more people are putting in orders for puts on a near term option than calls on the same near term option it is an indicator that short term the investors in that stock are thinking bearish.
The opposite is true if the call orders significantly outweigh the put orders.
The Chicago Board of Options Exchange publishes put/call ratios on its website at the end of every week of trading.
The data must be looked at in context because it is a measure of what has already happened, yet at the same time it is gauging the sentiment of investors as they prepare for the following week of trading.
A ratio of 1.
0 means that the same number of calls and puts were traded in that week of trading (remember, this is on all traded options not just one index or stock).
A ratio higher than 1.
0 means more put than call orders and less than 1.
0 means more call orders than put orders.
But a 1.
0 ratio is not considered to be even or non-directional.
Because most traders are more optimistic by nature an even ratio of call and put orders is actually considered to be more on the bearish sentiment side and a ratio of.
85-.
90 is considered more balanced.
This of course also means that a ratio below.
85 (meaning for every 1 call order there is.
85 put orders) is what investors would consider a bullish sentiment.
The farther below.
85 you go in the ratio (meaning the stronger the call orders are outpacing the put orders) the stronger bullish the sentiment.
Conversely, the higher above 1.
0 the ratio the more bearish the sentiment.
While the CBOE put/call ratio gauges sentiment on the market overall, you can gauge investor sentiment on an individual stock simply by looking at an option chain and examining the put/call ratio on that particular stock.
A stock can have short term sentiment that is very bearish while having a long term bullish outlook like in the figure below.
This will help you decide how you should play the stock yourself, but you have to keep in mind that this is simply following the crowd.
That in and of itself is not a bad thing, but your trades should be based on more than just following what others are doing.
As with many individual components of trading put this into context of the big picture.
2.
VIX The ticker symbol for the Chicago Board of Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility is VIX.
It is constructed using the implied volatilities of a wide range of S&P 500 index options.
This volatility is meant to be forward looking and is calculated from both calls and puts.
The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".
(From investopedia.
com) More often than not when the indexes are going down the VIX is going up because bearish markets are either a result of or help cause "fear".
(Notice that when the DOW Jones Index is going down the VIX is going up.
) The VIX measures fear in the market and fear often means bears.
The difficult thing about the VIX as an indicator of sentiment is that it really just states the obvious.
This is because the number you are seeing is an indicator of what happened that day and on a day when the market indexes drop 2-4% you simply expect the VIX to be high.
Anything above 20 on the VIX means that fear is relatively high and that hedging your positions is not a bad idea.
The best way to read the VIX is to see if volatility is still very high after a bullish day in the market.
This is often referred to as a deviation and may help you if you are undecided on a trade.
For example you might be thinking that after a strong bullish day in the DOW that it's time to buy back some covered calls that are being used to hedge a long stock position, but a look at the VIX could give you pause if after that bullish day the VIX is still quite high.
This means that in spite of a bullish day, fear is still prevalent in the market and waiting a day or two would be more prudent.
Like other indicators, use the VIX as one measure of what is going on in the market, but not the only one.
3.
General Market Conditions When you are looking at technical indicators such as the 5/20 day EMA or the RSI or MACD to see if a stock is moving bearish or bullish, look at the same indicators on the indexes.
Don't ever forget that even though the DOW Jones Industrial Average only measures the 30 largest companies in the US, 85% of all publicly traded companies follow its lead.
If the DOW gives bearish technicals the company you are trading has an 85% chance of following.
So if you are trading a stock in the opposite direction of the general market make sure you have very good reason to do so.
Too many times in my trading experience I have seen a company report great earnings, give a good guidance or outlook statement for the next quarter or even the next full year, and still not be able to overcome the momentum of a bearish market.
Stocks like AAPL, BA, and CAT in spite of being big fundamentally sound companies are still very prone to follow what the rest of the market is doing.
4.
World Events War; hurricanes; political contests - all of these things can have an effect on what the markets will do.
While you don't have to be a news junkie, you do have to pay attention to what is going on around you and place your positions accordingly.
News events will often times only effect a stock's short term movement, but bigger global events like the Iraq War can put major pressure on the stock market.
A great example of political events effecting market sentiment is election times.
When there is a real chance of political powers changing hands, people can either get very optimistic or get very scared.
It doesn't matter what your personal politics are, you just need to be aware that politics comes in to play probably more often than we would like.
At the time this article is being written the 2010 midterm Congressional elections are only months away.
The balance of power in the United States House and Senate could possibly change from very liberal to split or slightly conservative.
Don't believe for one second that this potential change won't affect the markets.
It will! Time will only tell what change may come, but change in the political landscape often brings change in the financial landscape.
Today more than ever we are becoming a global economy.
Recent news about the financial solvency of countries in Europe is having a huge effect on the markets in the United States.
Reports of banking and finance in China can cause our own markets to rise or fall depending on how the news affects the average consumer or the US as a whole.
It is more important than ever to keep an ear to the ground on things that can affect the US markets.
"News rules" on many days, weeks, and months in the stock market so never let yourself become out of touch with current events.
5.
Common Sense You don't always want to play "follow the leader" but remember that volume moves the market direction.
If all the fish are swimming upstream you could be bold and move the other direction, but in stocks and options that kind of attitude will most likely end in trouble.
Pay attention to everything and make sure you place trades that if the worst case scenario happens, will not blow up your portfolio.
If you go into every position looking at the worst case scenario and you have a plan that deals with a trade gone bad, you will come out ahead more often than not and be a very successful trader.
Having the pulse, or being in the know, or having an ear to the ground, or however you might want to say it is what we refer to as market sentiment.
Investopedia.
com defines it like this: "What Does Market Sentiment Mean? The feeling or tone of a market (i.
e.
crowd psychology).
It is shown by the activity and price movement of securities.
For example, rising prices would indicate a bullish market sentiment.
A bearish market sentiment would be indicated by falling prices.
" Most people believe that gauging market sentiment is as easy as turning on CNBC and listening to the talking heads in the morning, or watching Jim Cramer's Mad Money show to see how he feels about what's currently going on in the markets.
While neither thing is necessarily bad, there is a lot more that goes into gauging market sentiment than just one person's opinion.
No one news show or financial talking head should ever be taken as the all knowing soothsayer in what the markets will or will not do.
Market sentiment goes a little beyond simple rising or falling stock prices.
It is also about trying to predict as accurately as possible what direction the market is more likely to move in the future, near and far term.
Always remember, "more likely", not absolutely! Market sentiment can be gauged in a variety of ways: 1) put/call ratios 2) VIX 3) technical indicators 4) news and general market conditions 5) common sense.
1.
Put/Call Ratios Put/call ratios are simply the number of puts being bought vs.
the number of calls being bought on the same stock or index in the same month of expiration.
It can be measured in short or long term expectations.
It gives an investor an idea of what the rest of the market is thinking.
If more people are putting in orders for puts on a near term option than calls on the same near term option it is an indicator that short term the investors in that stock are thinking bearish.
The opposite is true if the call orders significantly outweigh the put orders.
The Chicago Board of Options Exchange publishes put/call ratios on its website at the end of every week of trading.
The data must be looked at in context because it is a measure of what has already happened, yet at the same time it is gauging the sentiment of investors as they prepare for the following week of trading.
A ratio of 1.
0 means that the same number of calls and puts were traded in that week of trading (remember, this is on all traded options not just one index or stock).
A ratio higher than 1.
0 means more put than call orders and less than 1.
0 means more call orders than put orders.
But a 1.
0 ratio is not considered to be even or non-directional.
Because most traders are more optimistic by nature an even ratio of call and put orders is actually considered to be more on the bearish sentiment side and a ratio of.
85-.
90 is considered more balanced.
This of course also means that a ratio below.
85 (meaning for every 1 call order there is.
85 put orders) is what investors would consider a bullish sentiment.
The farther below.
85 you go in the ratio (meaning the stronger the call orders are outpacing the put orders) the stronger bullish the sentiment.
Conversely, the higher above 1.
0 the ratio the more bearish the sentiment.
While the CBOE put/call ratio gauges sentiment on the market overall, you can gauge investor sentiment on an individual stock simply by looking at an option chain and examining the put/call ratio on that particular stock.
A stock can have short term sentiment that is very bearish while having a long term bullish outlook like in the figure below.
This will help you decide how you should play the stock yourself, but you have to keep in mind that this is simply following the crowd.
That in and of itself is not a bad thing, but your trades should be based on more than just following what others are doing.
As with many individual components of trading put this into context of the big picture.
2.
VIX The ticker symbol for the Chicago Board of Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility is VIX.
It is constructed using the implied volatilities of a wide range of S&P 500 index options.
This volatility is meant to be forward looking and is calculated from both calls and puts.
The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".
(From investopedia.
com) More often than not when the indexes are going down the VIX is going up because bearish markets are either a result of or help cause "fear".
(Notice that when the DOW Jones Index is going down the VIX is going up.
) The VIX measures fear in the market and fear often means bears.
The difficult thing about the VIX as an indicator of sentiment is that it really just states the obvious.
This is because the number you are seeing is an indicator of what happened that day and on a day when the market indexes drop 2-4% you simply expect the VIX to be high.
Anything above 20 on the VIX means that fear is relatively high and that hedging your positions is not a bad idea.
The best way to read the VIX is to see if volatility is still very high after a bullish day in the market.
This is often referred to as a deviation and may help you if you are undecided on a trade.
For example you might be thinking that after a strong bullish day in the DOW that it's time to buy back some covered calls that are being used to hedge a long stock position, but a look at the VIX could give you pause if after that bullish day the VIX is still quite high.
This means that in spite of a bullish day, fear is still prevalent in the market and waiting a day or two would be more prudent.
Like other indicators, use the VIX as one measure of what is going on in the market, but not the only one.
3.
General Market Conditions When you are looking at technical indicators such as the 5/20 day EMA or the RSI or MACD to see if a stock is moving bearish or bullish, look at the same indicators on the indexes.
Don't ever forget that even though the DOW Jones Industrial Average only measures the 30 largest companies in the US, 85% of all publicly traded companies follow its lead.
If the DOW gives bearish technicals the company you are trading has an 85% chance of following.
So if you are trading a stock in the opposite direction of the general market make sure you have very good reason to do so.
Too many times in my trading experience I have seen a company report great earnings, give a good guidance or outlook statement for the next quarter or even the next full year, and still not be able to overcome the momentum of a bearish market.
Stocks like AAPL, BA, and CAT in spite of being big fundamentally sound companies are still very prone to follow what the rest of the market is doing.
4.
World Events War; hurricanes; political contests - all of these things can have an effect on what the markets will do.
While you don't have to be a news junkie, you do have to pay attention to what is going on around you and place your positions accordingly.
News events will often times only effect a stock's short term movement, but bigger global events like the Iraq War can put major pressure on the stock market.
A great example of political events effecting market sentiment is election times.
When there is a real chance of political powers changing hands, people can either get very optimistic or get very scared.
It doesn't matter what your personal politics are, you just need to be aware that politics comes in to play probably more often than we would like.
At the time this article is being written the 2010 midterm Congressional elections are only months away.
The balance of power in the United States House and Senate could possibly change from very liberal to split or slightly conservative.
Don't believe for one second that this potential change won't affect the markets.
It will! Time will only tell what change may come, but change in the political landscape often brings change in the financial landscape.
Today more than ever we are becoming a global economy.
Recent news about the financial solvency of countries in Europe is having a huge effect on the markets in the United States.
Reports of banking and finance in China can cause our own markets to rise or fall depending on how the news affects the average consumer or the US as a whole.
It is more important than ever to keep an ear to the ground on things that can affect the US markets.
"News rules" on many days, weeks, and months in the stock market so never let yourself become out of touch with current events.
5.
Common Sense You don't always want to play "follow the leader" but remember that volume moves the market direction.
If all the fish are swimming upstream you could be bold and move the other direction, but in stocks and options that kind of attitude will most likely end in trouble.
Pay attention to everything and make sure you place trades that if the worst case scenario happens, will not blow up your portfolio.
If you go into every position looking at the worst case scenario and you have a plan that deals with a trade gone bad, you will come out ahead more often than not and be a very successful trader.
