3 Insider Secrets to Raise Your Trading IQ

3 Insider Secrets to Raise Your Trading IQ

Sentiment analysis is the cornerstone of the way we at Schaeffer’s Investment Research approach the market. And in particular, over our nearly four decades of experience in the options trading industry, we’ve learned that it pays to take a contrarian approach to investing by going against the grain of consensus sentiment. In other words, to paraphrase Warren Buffett, we’re fearful when others are greedy and greedy when others are fearful.

To technicians and fundamental investors who thrive on quantified facts and figures, reading the proverbial tea leaves on investor sentiment might seem like a peculiarly subjective pursuit. So, to demonstrate just how critical sentiment analysis is for successful investing, here’s an inside look at three of our favorite (data-driven!) indicators, and how they can give you an edge over the rest of the crowd.

1. Investor Sentiment Polls 

Investor sentiment surveys generally offer a head-to-head comparison of the percentage of respondents who are bullish versus those who are bearish. Two of the most popular surveys we track are those compiled by Investors Intelligence (II), which conducts a weekly poll of financial advisors, and the American Association of Individual Investors (AAII), which asks its membership each week whether they’re feeling bullish, bearish, or neutral toward stocks.

As contrarians, we look for situations where these surveys show a high percentage of pessimism while stocks are moving higher. This indicates to us that not everyone has bought into the rally, and there are still plenty of sideline buyers who could contribute to additional upside.

Conversely, sentiment surveys showing a glut of optimism even as the market’s technical backdrop is breaking down could be a troubling sign of more downside ahead as the remaining bulls are eventually shaken out of their positions.

Since the AAII and II surveys are weekly data releases, we’ll often smooth out the “noise” created by the week-to-week fluctuations in these indicators by instead tracking 10-week moving averages of the percentage of bullish and bearish respondents. This provides us with a bird’s-eye view of how sentiment toward stocks is developing and changing in response to market headlines and technical developments.

On the chart below, notice how the spike in the 10-week moving average of AAII bears to a multi-year high north of 40% coincided almost exactly with the late-2018 lows in the S&P 500 Index (SPX). Our quantified data suggests that this type of bearish sentiment climax typically precedes equity outperformance — and the big rally to start 2019 proved that out.

More recently, the rapid reversal in this bearish trendline to a low beneath 25% signaled possible short-term underperformance in the market, with this mid-April warning sign flashing just weeks ahead of the early May sell-off in stocks.


2. Short Interest

As you may already know, short interest is the number of shares sold short on a given equity. Short interest is created when an investor sells stock that is borrowed from a broker in the hopes of buying the stock back at a lower price in the future. In other words, the trader is looking to profit from a drop in the share price — essentially setting up a “sell high, buy low” scenario.
A high level of short interest signals pessimism, since it indicates a relatively large number of investors are banking on shares to fall. When short interest is high, and the underlying stock rises, the positive price action can force short sellers to buy back their shares to limit losses. This “short covering” activity results in additional buying pressure for the stock. One of our favorite broad-based sentiment indicators is the total short interest on all S&P 500 component stocks.  We’ve found that when this metric is high relative to past levels and begins to roll over in the face of higher stock prices, it can suggest an imminent leg higher for the market. As the short-covering gathers momentum, it can produce significant buying pressure.

On the other hand, steady or increased short-selling activity can create additional headwinds for a stock market that’s already struggling. As such, it’s key to gauge the overall trend in SPX component short interest, and consider it in the context of the current price action.

Looking at the graph below, note that most of those big, fast spikes in SPX component short interest have coincided with equally rapid-fire downturns for stocks, as selling temporarily overwhelms buying demand. Meanwhile, the market climbed a “wall of worry” during much of 2017 as short interest grew more gradually, capped off by major short-covering activity into year-end that eventually propelled the SPX to its January 2018 peak.

3. 10-Day Equity-Only Put/Call Volume Ratio

This last indicator is one that we created in-house here at Schaeffer’s from the raw data that we receive from options exchanges, in order to drill down on sentiment among retail-level speculators. And rest assured, our 10-day, equity-only, buy-to-open put/call volume ratio is notthe typical put/call ratio that you might find elsewhere.

First, this metric focuses specifically on equity options, which filters out a lot of the hedging-related volume on exchange-traded funds (ETFs) and indexes — which can muddy the sentiment waters. And second, this ratio only measures puts and calls that were bought to open, rather than grouping together both buyer- and seller-initiated trades. Again, this helps us to paint the clearest possible picture by eliminating premium-selling strategies that might have a more ambiguous sentiment motive (or no particular sentiment-driven motive at all!) relative to straightforward bullish call and bearish put plays.

Broadly speaking, when the 10-day, equity-only, buy-to-open put/call volume ratio is at high levels, it points to a high degree of pessimism among options traders. This is the kind of environment where stocks might be ripe for more upside, assuming the technical picture is favorable, since it suggests a relatively high degree of bearishness toward equities.

And when this ratio is low, it’s indicative of optimism — which might mean that stocks are running out of fuel to sustain a move higher, or may even be vulnerable to a sell-off or correction, since traders are pricing in plenty of optimism via their equity call option purchases. As such, the 10-day, equity-only, buy-to-open put/call volume ratio gives us a unique glimpse into the real-time sentiment of traders.

Per the chart below, the recent low in this metric occurred on April 29, 2019, at 0.508. This matched the prior low reading from Sept. 26, 2018, and signaled a relative extreme in optimism among this group — and that left the market vulnerable to a sell-off in early May. In fact, just over a week after this indicator troughed, the stock market was officially off to its worst month-to-date start of the calendar year.

 

 

Matthew Timpane, CMT, is senior market strategist at Schaeffer’s Investment Research, a privately held publisher of stock and options trading recommendations headquartered in Cincinnati, Ohio. Founded by CEO Bernie Schaeffer in 1981, we’re celebrating 38 years at the forefront of the thriving options industry. From our flagship Option Advisor newsletter to our expertly curated array of real-time trading services, we’ve got options for every investor.

 

 

 

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