Saturday, October 08, 2016

Assessing Positioning in the Market: A Measure of Pure Sentiment

Traders are often concerned that their ideas might fail simply because they have become "too consensus".  That is, if many other participants are positioned in the same idea, the risk/reward may become negatively skewed.  There aren't many traders left to move the position further in the desired direction and, should prices start to move the other way, there can be a stampede for the exits quickly putting positions under water.

Sentiment in the stock market is one way of gauging market psychology and whether there may be a bullish or bearish consensus.  Unfortunately, the standard measure for assessing sentiment, the put/call ratio, has several weaknesses.  First, it often mixes together put and call trading for stock index options and for the options on individual equities.  My work shows those are different distributions, with different impacts on markets.  The equity-only put/call measure, where options across all exchanges and all listed issues are included, has been the best measure for sentiment.  A second problem with the standard put/call ratio is that it is itself impacted by past price movement and volatility.  When markets rise, the ratio tends to decline and vice versa.

The pure sentiment measure I created is akin to the pure volatility measure, which adjusts implied volatility for the amount of realized volatility and past price movement.  Pure volatility thus tells us how much movement is being priced into options for a given amount of recent movement and realized volatility.  In other words, it shows us how VIX may be under-reacting or overreacting to recent price behavior.  Similarly, pure sentiment adjusts the put/call ratio for recent price movement and volatility.  The pure sentiment measure (shown above) tells us when we are "too" bullish or "too" bearish, given recent price behavior.

Interestingly, going back to 2014, pure sentiment has been a decent near term predictor of stock index prices--so much so that I added it to the ensemble model recently described.  By a simple median split, when pure sentiment has been high (too bearish for the amount of market movement we've seen), the next ten days in SPX have averaged a gain of +.71%.  When pure sentiment has been too low (too bullish for the amount of recent market movement), the next ten days in SPX have averaged a loss of  -.17%.  The numbers stand out even more at the extremes.

Notice how, in the recent market, we've had quite a few high readings in pure sentiment.  (Friday closed bullish on the pure sentiment measure; the overall ensemble model closed at a flat 0).  We've seen weakening breadth in stocks and many participants have been anticipating a market top, but prices have tended to bounce higher after we've seen selling.  The bearish sentiment/positioning may have something to do with that.  It's a facet of the market I'll be tracking closely in coming days.

Many, many market indicators can be improved by looking at whether and how they anticipate forward price movement once correlated market factors are removed.  It doesn't help to look at 12 different market indicators if they all are significantly correlated.  When we remove the correlations, we come closer to measuring the true factors that move stock prices.

Further Reading:  Pure Volatility