Contrary to Sentiment


Guest Author
Just want to share with you one of the best pieces of advice on trading that I have ever read. it's from John Carter's Mastering The Trade, and simplistically describes how the markets work and how and why they move.
In the chapter on market internals "Seven Key Internals" he discussed market breadth and sentiment indicators such as $TICK, $TIKI, $TRIN etc. The following paragraph is in the section on the Put-Call Ratio ($WPCVA)(subtitled "the Keys to the Kingdom") but I believe this notion of Contrarian trading applies to most of the market sentiment indicators too.

"To illustrate how I use this indicator, let's assume that the market is made up of exactly 100 participants. Let's further assume that all 100 of these people are bearish on the markets, and because of this bearish feeling, they have established short positions in stocks, ETFs, and index futures, as well as through the buying of Puts.
With all 100 market participants bearish and now short, a very interesting turn of events takes place - there is nobody left to sell. With nobody left to sell, the markets don't have any downward pressure, and they start to drift higher.
This drifting eventually hits the first set of Stop orders placed in the market by the 100 market participants who are short.
Within any group of traders, some will be using tight Stops, some medium Stops and some wide Stops. The group of tight Stops gets hit first, and this generates fresh buying pressure in the form of short covering that drives the market higher right into the next range of Stops.
This next series of Stops kicks off yet another short covering spress, which, once triggered, drives the market even higher into the next range of Stops, and so on until all the Stops are taken out.

At this point the 100 market participants get bullish, and start buying stocks and index futures, as well as call options. Once they all scramble to establish their positions, a very curious thing takes place - there is nobody left to buy. With nobody left to buy, the markets begin to drift lower and take out the first Stops, which in turn creates enough selling pressure to drive the markets down to the next set of Stops, and so forth. It's a vicious cycle.

Obvioulsy this is a simplified scenario, and in the real world not every single market participant is going to be bullish or bearish at exactly the same time. However, the amount and intensity of bullish and bearish bias does fluctuate regularly, and this shift in attitude causes markets to move in a fashion related to the "oversimplified scenario" just described.
This brings me (John Carter) to my first rule regarding the PC ratio:

If the combined equity/index PC ratio gets over 1.0 intraday, I will ignore all short set-ups and start looking at long set-ups.

A PC ratio of over 1.0 represents extreme bearishness and Put buying, and, as a result of the scenario described above, places a floor in the markets. Not an immediate floor. The ratio doesn't go to 1.0 and then suddenly the markets stop declining and then immediately rally. It's a process, and a visible support level does take shape because of the simple fact that there are too many bears in the market - and lots of buy Stops sitting overhead, just waiting to be taken out.
These 1.0 readings usually happen when the markets have fallen for a number of days in a row, or bad earnings or economic data hit the tape, suddenly infecting many market participants with a bearish outlook. In fact, many times a market will continue falling until the PC ratio gets over 1.0.
The opposite extreme is also true, which brings me to my next rule:

If the combined equity/index PC ratio falls under .60 intraday, I will ignore all long set-ups and start looking at short set-ups.

A PC ratio of under .60 represents extreme Call buying and puts a ceiling in the market. this represents a scenario in which there are too many bulls and very few people left to buy. Now there are lots of sell Stops sitting beneath current levels, just waiting to be hit"
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As with any indicator there are supporters and detractors. I’m undecided; here are my thoughts/observations.

I’m being selective in my data because it illustrates my point(s). Of course, this may prove exceptions to the rule but then one would need to account for these. The data refers to DAX options.

Perhaps volume is too imprecise and we could look for other/supporting indicators.

25 Oct 07

Mar calls volume = 30,929
Mar puts volume = 10,522
p/c ratio = 0.3

Mar calls value = Eu 119.3m (total volume x premiums)
Mar puts volume = Eu 15.4m
p/c ratio = 0.1
very bullish

Mar calls futures esp = 61m (equivalent stock position: volume x delta)
Mar puts futures esp = 4m
p/c ratio = 0.06
bet the farm.

3 Oct 07

Oct calls volume = 36,481
Oct puts volume = 46,240
p/c ratio = 1.3

Oct calls value = Eu 31m (total volume x premiums)
Oct puts volume = Eu 23m
p/c ratio = 0.7

Oct calls futures esp = 17m (equivalent stock position: volume x delta)
Oct puts futures esp = 9m
p/c ratio = 0.5
very bullish.

Further thoughts.

Is a 1000 lot at 15% implied the same as a 1000 lot at 25% implied?
Is a 1000 lot at 0.25 delta the same as a 1000 lot at 0.75 delta?
Is a 1000 lot at 30 days expiry the same as a 1000 lot at 60 days expiry?

Regardless of which figures one uses the major problem is the inability to differentiate longs from shorts.