Three Option-Related Warning Signs of a Market Reversal

12/10/2010 12:01 am EST

Focus: OPTIONS

Price Headley

Founder and Chief Analyst, BigTrends.com

In my 20-plus years of option trading and educating investors, there are certain factors that we've seen time and again can help foretell when the market is on the verge of a trend momentum switch.

Beyond technical analysis indicators, we also utilize sentiment and volatility-based measures that can often give us the "early warning" that something may be amiss in the markets.

The first of these is the CBOE Volatility Index (VIX), which I've been analyzing and utilizing since the early 1990's. The VIX measures in the implied volatility of S&P 500 Index (SPX) options- this is a factor that is basically human controlled and has swings based on supply and demand for options. To a large measure, it measures the "fear factor" in the market among option traders.

In recent years, VIX movements higher have tended to indicate that something is not quite right in the stock market and that large-scale selling may be imminent. For example, take a look at the following chart of the VIX and SPX from earlier this year:


Click to Enlarge

In the above chart, you can see that the VIX (green) moved above its top Bollinger band (aqua bands) in April before the market topped out. There was even another early warning about a week earlier where the VIX breached its top band but closed below it. Another bigger seismic move in the VIX followed at the beginning of May. The result: The stock market (SPX in yellow) dropped nearly 20% in the two months following this VIX move!

There are two other sentiment and volatility measures that we utilize to find the big market trends early on. One of these is the put/call ratio. This measures the trading (mostly among the public) of option puts and calls. We use unique indicators to track both the CBOE Equity-Only Put/Call Ratio and the ISE Inverse Call/Put Ratio. We will often see a suspicious spike in these measures before the market makes a big move, and on the inverse, there are times when these become contrarian indicators and tell us that the current trend will continue.

Finally, a third broad-based measure we utilize to determine whether a market trend shift is imminent or will continue and/or strengthen-let's call this sentiment, media, and surveys.  This is more of a contrarian (going against the prevailing wisdom) indicator in many cases- we've seen countless examples of mass media panic at times of huge market bottoms and "Buy stocks now" articles when a bearish trend occurs, for example. Remember how many articles there were about "Easy money in real estate" right before the bottom dropped out of that market? We've seen that time and again and recognize when bubbles will burst. 

Even "fading" (going against) some of the online touts can be utilized by the knowledgeable trader. And we know how to trade the reaction to news events, which is more important usually than the news event itself. Another example is investor sentiment surveys, such as the prominent one by Investor's Intelligence. This measure of bulls/bears will often provide very good short-term contrarian signals for the markets when it reaches extremes.

Keep an eye on the VIX, put/call ratios, and media sentiment/investor surveys and you can often see whether the current market trend is due for a huge imminent reversal or whether you can ride the trend higher for further profits.

By Price Headley of BigTrends.com

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