Intermediate-Term Sentiment Indicators For Spotting Market Bottoms

My intermediate-term market view starts and ends with the market itself. First comes the trading action of high relative strength stocks (the waters I fish in). Then I look at the major averages and market volume. Everything else is secondary. I act only when evidence comes in strong from top-performing stocks and the Dow or the Naz.

With that preamble, I still find other, secondary indicators useful in judging market climate. I take monetary conditions into serious consideration. Among other monetary gauges, I keep a weather eye on the yield curve, quality yield spreads and the fed funds futures. During correctional or bear markets, I use options volume to flag the kind of panic selling that can form durable bottoms, setting the stage for a fresh rally.

As an intermediate-term momentum trader, I trade with the trend. However, all trends end. Often, the end comes after the trend becomes too obvious. A rally hyper-accelerates as greed whips the crowd into a buying frenzy. Once demand becomes exhausted, the downside reversal ensues. In like fashion, a correction hyper-accelerates as shareholders at last give way to fear. A capitulation sell-off occurs, then the market reverses to the upside. 

To detect market turns, I look first to the behavior of individual stocks and the broad averages. But psychological indicators such as those based on options activity can throw confirming light on a situation. If they register the extreme levels of greed or fear consistent with peaking or bottoming action on the indexes, I probably will feel reinforced in my read of the market's message and act more deliberately. If my secondary indicators contradict my primary indicators or render an inconclusive signal, I might still proceed based on my primary indicators. However, I may have less confidence in my market assessment, so I may proceed less aggressively on that assessment.  

Like many other traders, I have found sentiment gauges to be more useful in spotting bottoms than tops. Fear is a more powerful emotion than greed. As a result, bear markets typically conclude in sharp, explosive sell-offs, characterized by dramatic expansions in daily range on the indexes and in market volume. On the other hand, general market tops often form gradually. In some tops, the averages roll over slowly, ponderously, like an oil tanker changing course. You're more likely to see sharp, violent tops in high-momentum industry groups. For more on this trading action, see my lesson on climax tops.

To form a durable bottom, a correction or outright bear should climax in a capitulation sell-off. The idea here is that the weak holders, shareholders with paper losses, panic and throw away their shares at fire sale prices. In the turnover, a fresh class of bulls buys stock with both hands. The best sign of this would be sharp decline in the major indexes followed by intraday or next day recovery, on powerful market volume.

Consistent with such sell-offs is a steep increase in put option volume. Most traders look at put activity in comparison to call option activity. This is most often done by dividing put volume by call volume, yielding a put/call ratio. 

The idea behind using option activity to spot a bottoms is pretty straightforward. Option buyers are regarded as speculators. Speculators, as a crowd, tend to be wrong at market extremes. Buying a put is a bearish play. It confers upon the owner the right, but not the obligation, to sell the underlying security at a specified price. So the put buyer stands to benefit from a price decline in the underlying security. So an extraordinary surge in put volume can flag excessive bearishness the prevails at a bottom. (Buying a call is a bullish play. It confers upon the owner the right, but not the obligation, to buy the underlying security at a specified price.)

You can use any number of tools for measuring sentiment with puts and calls. I look at total options volume on the Chicago Board Options Exchange. That means that I am looking at the combined index and equities options activity. I like to see both a big surge in raw put volume as well a spike in the put/call ratio above 1.1 on a closing basis. Other traders like to use just put and call options on individual stocks on the CBOE. Hedge fund manager Greg Kuhn, who trades intermediate term, often refers to a 15-day CBOE equity-only put/call ratio. John Bollinger, a money manager and technical innovator, has developed a bottom-flagging signal that compares equity and index put volume on the CBOE to its 10-day moving average. 

The CBOE publishes a breakdown of option volume as well as a put/call ratio based on total options activity in its market statistics summary on the Web. The page provides historical data as well as stats from the last close. 

There are several points to bear in mind. 

1. As I pointed out, successful traders use a variety of put or put/call gauges in their sentiment work. The key is to familiarize yourself with your chosen indicators behavior during trending and reversal phases of the stock market.

2. No signal is 100% accurate. An indicator with 50% accuracy would be a strong signal. Put/call signals, used alone, are weaker still. Never try to time the market entries or exits based exclusively on options volume or ratios.

3. Intermediate-term momentum traders should take the market at its word. That means looking first to the trading action high-performance stocks, general market volume and broad indexes. In my own work, a strong consensus from those primary signals probably will trump a contradictory signal from weaker secondary indicators like put/call ratios. However, a contradictory signal from a secondary indicator might be cause to be on my guard. I'll show an example shortly.

The last clear bottom signal from the put/call ratio came on Oct. 8, 1998. The Nasdaq Composite tumbled 8.1% to an intraday low of 1343.87 before paring its losses to close at 1419.12, off only 3.0% and closing in the upper half of the day's session on huge volume. The S&P 500 fell 4.9% to an intraday low of 923.32 before paring losses to close at 959.44, off 1.1% and in upper quarter of the day's range.

Coinciding with the Oct. 8 reversals were extreme fear readings in the options markets. Equity and index put volume swelled 65% to 742,413 contracts on the CBOE from 448,811 contracts on the prior session. The put/call ratio rose to 1.27 from 0.94. In hindsight, we know the Oct. 8 session formed the trough of the summer 1998 bear market and the beginning of the subsequent bull market.

As I said before, I will not buy into a bottom until confirmed by subsequent tape action -- preferably in the form of an O'Neil follow-through day -- and a growing number of high RS stocks setting up in proper bases and breaking out.

I don't need panic sentiment readings to re-enter the market after an apparent reversal following a bear market provided the follow-through day occurs along with breakouts by high RS stocks. However, recent history suggests that the absence of capitulation signals from the options gauges is reason to the follow-through day a bit more cautiously. The FTD is one of the best signals that a prior reversal has given rise to at least a tradable rally. But as I said before, no signal is 100% reliable.

For example, the market delivered a follow-through day on June 2, 2000 on the Naz subsequent to a reversal off its then-low of 3042.66 on May 24. The May 24 session had a number of qualities for a good reversal. Heavy volume, intraday reversal off a new low of the bear market, a close at the top of the day's range. However, while bearish put and put/call activity expanded, it did not register the rampant fear that was so convincing, for example, in the Oct. 8, 1998 precedent. 

The FTD was good for a few trades. There were valid, profitable breakouts during this phase. But this was not the kind of full-bore rally awaited by the intermediate-term trader. The rally-within-a-larger-bear-market peaked on July 17, then rolled over. So again, the lesson I would take from this is as follows: I would still trade the follow-through day if I got breakouts in high RS stocks, even with unconvincing negative sentiment readings on the earlier reversal day. But I'd probably be less aggressive in the initial rally phase than would be the case if the reversal day registered powerful negative sentiment.

For the similar reasons, traders should treat the current bounce off the Nasdaq Composite's Nov. 30 low with skepticism. If the rally produces a follow-through day and high RS stocks set up and breakout, I would trade it. But I'd probably be less aggressive than if the Nov. 30 low had coincided with high fear readings on the put/call ratio.

The following chart shows the Nasdaq Composite and CBOE put/call ratio through Dec. 1. Note that while the Naz headed south over the past three weeks, the put/call ratio actually declined. Instead of falling prey to panic and bailing, speculators have grown more bullish! On Nov. 30, the put/call ratio actually fell to 0.75. This is the exact opposite of what one wants to see in the formation of a bottom.

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