The options market is, by its nature, very speculative. Options are highly leveraged tools that allow investors to “control” a large block of shares with relatively little down. This control only applies if the stock is at a certain price within a certain time, however, and this is why the options market is risky and speculative. The buyers of call or put options are prompted into action when they are more optimistic (greedy) or pessimistic (fearful) than usual. Measuring the options market is a good gauge for overall sentiment, since this market is speculative in nature and will tend to represent extremes.
By analyzing the CBOE put/call ratio – that is the total number of puts traded per day compared to the total number of calls traded – one can get an accurate reading of the temperature of the market. Most of the time the put/call ratio is within a normal range and offers little guidance. However when the ratio reaches extremes it may indicate a temporary bottom. As a Market Technician, remember that sentiment indicators are better at determining bottoms than tops, since greed and fear are not polar opposites. Greed can exist for long periods of time, while fear often reaches a head and climaxes.
I don’t think the chart below needs much explanation. The total CBOE Equity Put/Call Ratio is graphed below the S&P 500 average. Notice anything uncanny regarding temporary bottoms? Is it any wonder why Market Technicians are taught to analyze sentiment trends? Despite the recent success of this gauge, remember that no technical indicator is ever guaranteed, and proper risk management control should always be practiced regardless of the strength of a signal.
Total Equity Put/Call Ratio on a daily chart
The S&P Volatility Index, or VIX, as it is, can give a technician valuable information regarding the health of the market. The VIX seeks to estimate fear in the marketplace by examining out of the money puts and calls on the S&P for the front and second months expirations to arrive at a 30-days forward estimation. The calculation uses a system that takes into account the price of options premiums, as these premiums increase as the market becomes more uncertain as volatility and fear mount.
The VIX typically rises when markets decline, and falls when markets rise. Generally, the faster the decline, the higher the VIX climbs. For this reason VIX will peak around market bottoms. You can think of the VIX as the emotion of the market. A high VIX reading signals a highly emotional market. This means investors are fearful, and it also means they may be acting irrationally. At some point more rational decisions will overcome the fear. But the billion dollar question is when?
With one of the worst weeks in two years, and the Dow falling just shy of 700 points on the week, many investors may be tempted to call a bottom in the markets. The market suddenly appears “cheap” to many investors who see their stocks trading down double digit percentages from where they were only weeks ago. The truth of the matter is that the VIX has been rising and may well continue to do so for the next few days or weeks. Prices may seem relatively cheap but perhaps they are still overvalued. Though the market was flat on the day, prices hit new lows, and the VIX hit new highs. The VIX is flashing the warning sign: yes, things could get worse. It could also be raising the white flag, but we wouldn’t know it until much later.
I’ve imposed a price chart of the S&P below the chart of the VIX. As you’ll notice, in the two cases of VIX spikes before, the VIX peaked well before the market stopped its descent. What this means is that even if the VIX has peaked, the markets are still more likely to continue to fall. The final fallout from the market crashes of October 2008 was not reached until finally 5 full months later in March 2009. And yet you can clearly see the VIX peaked around 80 on a weekly basis months before the March 2009 lows. The markets will bounce in time, but whether it is a technical bounce or the continuation of our multi-year uptrend remains to be seen.
The investor’s takeaway from this – if they have cash – is to stay out. You could call the bottom, but you could also minimize your risk by waiting and watching. Technical analysis is a study that provides new information daily, so why not wait until a bottom is more clearly visible? The market is telling you it is overheated. Uncertainty is increasingly rising. It may be safest to wait and look at the markets from afar after the dust has settled and then determine the most suitable strategy going forward from that point.