Today, I want to start talking about market sentiment indicators. What are those? Well, a market sentiment indicator is just what it sounds like: an indicator that helps gauge market sentiment regarding bullishness vs. bearishness. First, let’s take a look at what the market has been doing:
As you’re no doubt aware, the market began selling off in September, and it pulled back to the 50SMA, which acted as support for a few days before finally breaking through and hitting a low at the beginning of October. Since then, the market has been recovering strongly, and we’re already back to our all-time highs.
It is often helpful to gauge how market participants as a whole are viewing the market. You might ask why that’s helpful if most market participants are no more informed than you or I. It’s an interesting topic, so let’s see if I can shed some light!
I can’t remember now where I first read this, possibly in a psychology book such as Dan Ariely’s “Predictably Irrational” or Robert Cialdini’s “Influence,” but there was an experiment done to judge the wisdom of crowds. In the experiment, there was a large jar filled with many marbles, and participants simply had to guess the number of marbles in the jar by looking at it. Naturally, there were some ridiculous guesses such as “2” or “a million.”
And although most people did not guess the number of marbles correctly, the average of the guesses was actually surprisingly close to the actual number with even taking the extreme guesses into account.
The reason is because the too-low guesses balanced out the too-high guesses, and ridiculously large numbers were balanced out by ridiculously small numbers, and so the result of all of the guesses combined came out to a reasonable number that was very close to the actual number of marbles in the jar. You can bet your bottom dollar that there are similar mechanics at work in the stock market.
Now, am I saying that the crowd is never wrong and you should always do what everyone else is doing? Of course not. But in a complex system like a financial market, the crowd as a whole can provide us with very useful insights as to what the market is thinking.
Several valuable indicators can help us with this task, and the one I want to share with you today is the Put-Call Ratio. The Put-Call Ratio is an indicator that measures the number of put options against the number of call options traded over a timeframe of usually one day. A put option gives the buyer the right to sell a security, while a call option gives the buyer the right to buy a security, so more people buying puts is considered bearish while more people buying calls is considered bullish. By default, a ratio higher than one would mean a greater number of put buyers and thus bearish sentiment. At the same time, a ratio lower than one would mean a greater number of call buyers and thus bullish sentiment.
However, this is not an accurate comparison because calls are normally bought in much higher volumes than puts. In order to balance this out, it is common to use a number lower than 1.0 as the baseline average for gauging sentiment. A great way to view this indicator on TradingView is to simply search for the symbol “PCC,” and it looks like this:
I’ve taken the liberty of adding this chart right below the chart of the S&P 500 from earlier, so you can see exactly where sentiment shifts from more bullish to more bearish and vice versa, taking care to make sure the dates line up exactly, as well as adding an average baseline around the 0.85 level:
If you look closely at the chart, you can see the moments when the Put-Call Ratio was lowest, just when the market was topping and about to pull back. Similarly, if you look at the bottoms of the dips on the S&P 500 chart, nearly all of those days mark a peak in the Put-Call Ratio indicator. That’s why many traders and investors choose to use the Put-Call Ratio as a contrarian indicator; meaning, when it shows extreme bullishness or extreme bearishness, they view it as a signal to do the opposite.
At the moment, the indicator is at 0.75 -- not an extreme reading, but certainly heading into “overbought” territory. Given the sharp rise in the S&P 500 over the last week, this isn’t terribly surprising. Either way, it’s an important indicator to keep an eye on moving forward, and when you see moving into an extreme high or low, it could be a good idea to start being cautious: the trend is likely about to change. As always, it is critical to follow a solid trading plan no matter what indicators you use. Conducting proper analysis, structuring your trades for asymmetric returns, and managing your risk wisely will help you make money in any market environment.
If all this talk about puts and calls has you confused, I’d strongly encourage you to check out the Options Accelerator program at TSU! It’s designed for brand new, beginner, and intermediate option traders who want to learn how to trade options properly and profitably. You can get more info here.