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Options as a Sentiment Indicator

April 28, 2008

Movements of stocks are a hell lot of a black magic to perceive. And added to it, the smoke screen of media, with its smart ass comments do little to clear the screen. Take for example, in April first week, Indian inflation touched 3year high, 7% and markets came tumbling down. As obvious,comments like these were thrown pence a dozen.

Market crashes on the back of 3 year high inflation rates


[Moneycontrol]

And when exactly a week later, the Indian inflation rates were out it touched an all time high of 7.5% and incidentally the market soared. Media didn’t even mention it… oops!
So where are the traders, speculators and investors in the scheme of things? First, if anything at all, stop following media for fresh global cues, and market explanations. Its very easy to attribute the movements of the markets to something after it has happened, that too in an off-the-cuff way.

Secondly, if anything, convince yourself, that trading is essentially a psycho-socio-logical affair.Once you convince yourself of that, then the understanding comes like a deluge. So, on the back of this, once we understand that, trading is essentially a daily battle between optimistic and pessimistic emotions, although understanding becomes easy but predicting apparently becomes tougher. How do you attach, values to the emotions?[Seemingly contradictory, huh?]
Something like: My optimism index is up by 3.2% and pessimism index is down by 4.8% ???

Its a good news and a bad news that, sentiments can’t be measured in that way. Why good news, this is because if it was indeed measured, then it enters a deadlock. For example I am optimistic, and it is measured as an all time high of 7.3% [assume!], then what happens? What do I think?I may then start thinking “Am I being too optimistic, should I cut back on it”? So am I really then that optimistic??

But yes, its interesting we can interpret subjectively though, the overall sentiment gauges. Robert Prechter uses long term socio-economic indicators like music, fashion etc to understand. He uses in short term, cold blooded technical indicators to understand emotions.

But I guess, there is perhaps a more correrated, direct, simple and precise exhibitor of stock-wise sentiment indicator. It will be great isn’t it?
I was thinking, and came across this idea to observe option call depths to understand the overall sentiment. If the volume of out-of-money call options for a particular stock [say, MERCAT], is increasing then it reflects optimism, or otherwise pessimism.

But then, this is just a small crude measure. Bernie Schaeffer in the Option Trading Handbook, has come up with a far better,tweaked indicator. Measure the ‘out of money’ call volume to put volume ratio[lets name this ratio as Si. )
So,
Si[1 month]= Volume of OTM Call[1 month]/ Volume of OTM Put[1 month]

This will effectively give us short term, sentiment for a particular stock. By increasing the time period mid term and long term can be effectively harnessed. One disclaimer though, this sentiment indicator will be a leading indicator. Moreover, sentiment indicator will never suit intra day traders as sentiment is a sluggish indicator and changes far slowly than technical indicators. Economy oriented sentiment can be judged by checking out the similar Si ratio for indices.

Perhaps you can, tomorrow come up with a better indicator which effectively factors in socio economic perspective of the economy, and a particular stock to interpret better, if a stock is worth investing or not.But till then, lets make the best use of it.

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