Market Internals Every Swing Trader Should Be Watching
09/16/2009 10:12 am EST
In this article, I want to give you a brief overview of a series of tools used by many traders to measure the level of greed and fear in the market. These sentiment indicators will allow us to determine extreme levels of fear and greed, which oftentimes produce the more reliable two- to five-day moves on an average. We already know for a fact that most patterns, or set ups, in stocks tend to follow the general direction of the main averages. Thus, if we're able to determine not only trends and areas of support/resistance, but also extreme levels of fear and greed, we'd be able to more precisely pinpoint those moments in time where the odds of entering swings are greater. In order to better comprehend these sentiment indicators, we need to first understand the basic aspects of the elements that form such indicators (options).
Options are derivative contracts that provide their buyer with the right (but not the obligation) to buy (call option) or sell (put option) a predetermined amount of the underlying asset at a predetermined price (and at a predetermined date or before). People buy options both to speculate on a given market direction and to hedge (reduce or eliminate the market risk of) any given position.
Since the majority of market participants are biased towards the long side, most people will buy put options to hedge their long positions at moments of market weakness. Needless to say, most of the uneducated public will buy such hedges at the end of any given bearish move lasting several days, when the inevitability of a market drop is in front of their eyes (since the market has already declined). On the other hand, a vast majority won't worry about buying puts (or will buy calls to speculate) in an overly bullish environment, usually at the end of multi-day bullish moves.
With the above information, the experienced trader utilizes two distinct sentiment indicators to measure and observe the changes in bullish/bearish expectations of the market participants. One is the put/call ratio, while the second is the Volatility Index (VIX).
The put/call ratios are simple divisions of the total number of put options by the number of call options (this is an inverse indicator). There are several variations (equity, total, OEX), but they typically reflect the level of bearishness/bullishness of the market participants. If the general public is buying an exceedingly higher number of puts, after the markets have declined for several days, the odds of a bounce are higher. Extreme levels are above 0.8 (extreme bearish) and below 0.5 (extreme bullish), and we use five- and ten-period moving averages (5MA and 10MA) to smooth out the data. Thus, any multi-day move down in the S&P 500, accompanied with an extreme reading of the 5MA/10MA of the CBOE put/call ratio, would indicate odds of a market bounce at least short term (will depend on the trend of the market, other internals and actual areas of support). Keep in mind that this put-call ratio (usually the CBOE put/call ratio) follows the “bets” and expectations of the general public, while the OEX put/call ratio follows those of the “smart money” (institutional—not necessarily an inverse indicator).
The other sentiment indicator is the VIX. This indicator calculates the expected volatility of either the S&P 500 ($VIX.X) or the Nasdaq 100 ($VXN.X) using formulas that take into consideration stock index option prices. As a general rule, traders expect higher volatility in a bearish environment, while lower volatility is the norm in bullish environments. Again, this is another inverse indicator. Upward moves in the VIX will indicate increasingly bearish expectations. The opposite can be said for declines in the price of the VIX. Bearish reversals at major resistance in the VIX (amid a sideways trend) would come hand-in-hand with a potential bullish reversal in the market.
These are but just a few of the tools and tactics you can use to increase your odds as a trader. As with all internals, they act as confirmation tools, and we'll always need a price pattern in the stocks in order to trade them. Also, the best odds are most often attained whenever several of the internals mentioned in this article are in agreement.
By Simon Brad of of Pristine.com