Friday, December 29, 2006

What Is Options Sentiment Saying About The Start of 2007?

One of the joys of conducting analyses of historical market patterns is the discovery of relationships you hadn't anticipated. Sometimes those are mere anomalies; other times, they represent discoveries.

In my recent posts, I've been analyzing the put/call data for individual equities and for the equity indexes. As I was looking at relative put/call ratios for the equities (how the current ratio compares to the average ratio for a given lookback period), I noticed that we have had quite an elevated relative put/call ratio over the past four trading sessions. In other words, the put/call ratios for the past four sessions have been high (skewed toward puts) relative to the 20-day average ratios.

I decided to take a closer look at four-day elevations in the relative equity put/call ratio going back to 2004 (N = 734). When the put/call ratio for the past four trading sessions is more than 20% greater than its 20-day moving average (N = 62), the next 15 days in the S&P 500 Index (SPY) have averaged a gain of 1.31% (46 up, 16 down), quite a bullish bias. To state it otherwise, when the options traders shift heavily toward put volume over a twenty-day period, the next three weeks in the S&P 500 Index have dramatically outperformed their average. That would bolster the bull case for the start of 2007.

Now for the unexpected finding:

When the relative equity put/call ratio has been 10% or more beneath its 20-day moving average (N = 85), the next 15 days in SPY have averaged a *gain* of .95% (60 up, 25 down), again quite a bullish edge. We are accustomed to thinking of a low put/call ratio as extreme optimism and hence a bearish market indication. It appears, however, that when bullish sentiment shifts strongly over a 20-day period, the shift has bullish implications over the following three weeks.

I will be refining the methods I use to assess relative options movement, so consider this a work in progress. What I hope to determine is whether *changes* in sentiment are more important to market outcomes than absolute levels of sentiment themselves.


NO DooDahs said...

Yep. One of the rare times I'm levered, about 115% long for the start of the new year.

Anonymous said...


Have you tried running this study back to include 2000. This asymmetry shouldn't be of a surprise given the mini bull market.

Beliefs tend to persist until people see a reason to change them. In non-consensus conditions, diverse forecasts tend to balance each other (errors cancel). When the distribution of beliefs is narrow - prices are more likely to take larger swings as people change their beliefs.

I think your result highlights that on average, most people are optimistic (rising tide). However, when people become pessimistic, they become intensely pessimistic. Both the intensity and frequency of investors' changing beliefs about the market will affect market prices.

Brett Steenbarger, Ph.D. said...

Hi NO DooDahs,

My best wishes for the New Year bull!


Brett Steenbarger, Ph.D. said...


You're right; it would be very worthwhile to test out relative put/call ratios under different market regimes. Thanks for the suggestion--


Anonymous said...

Hi Brett,

Interesting find. I too would like to see the relationships under a less-than-bull market such as 2000.

However, I think your recent analysis' going back two years is appropriate considering the overall market sentiment has been bullish since 2004. I actually prefer the shorter term findings because the investment community seems to have a short term memory.

Have a great New Year!


Brett Steenbarger, Ph.D. said...

Thanks, Marc; I think you're pointing to the difference between examining a recent regime vs. developing an actual trading system, which necessitates a historical look over very different market regimes--


Anonymous said...

Dr. Brett ,

Thanks for your hard work in putting your deep , thoughtful , and invaluable research into this great blog . It has been of immense value to me and I appreciate all that you've done.
I've traded for more than 20 years in an institutional proprietary environment , and many things that I recognize and intuit , I see in your research . It has been very helpful

Best wishes for you and your family in 2007

Regards , HFT

Brett Steenbarger, Ph.D. said...

Thanks HFT,

The feedback means more to me than you can possibly know. Have a happy, healthy, and prosperous New Year--


Anonymous said...

Thank you for your hard work and generosity Dr. Brett. You definitely give much food for thought. It is one of the most, if not THE most enlightening Blogs/Websites I have encountered. I myself am short the market at the moment from what I see, but that's what makes a market...

Brett Steenbarger, Ph.D. said...

Thanks very much, Excelsior. I appreciate the feedback. Best of luck in 2007!