Thursday, November 09, 2006

Stock Market Sentiment Is Not Necessarily A Contrary Indicator

Sometimes the crowd gets it right.

Let's take the current market. We've been up over a three-day period in the S&P 500 Index (SPY) by over 1.5%. During those three days, the ratio of put volume to call volume among equity options has been .72. That's pretty much the average put/call ratio that we've seen since 2004 (N = 717 trading days) and slightly bearish for periods of solid three-day gain.

Since 2004, we've had 67 occasions in which SPY has been up by more than 1.5% on a three-day basis. The next day, SPY has averaged a loss of -.04% (32 up, 35 down), which is weaker than the average one-day gain of .03% (390 up, 327 down) for the sample overall.

But let's break it down by put/call ratio. When the ratio is greater than .70 over those three days (N = 33), it suggests that put buyers are more aggressive relative to call buyers. The next day, SPY averages a loss of -.22% (12 up, 21 down)--much weaker than average. When the ratio is less than .70 (N = 34) and call buyers are relatively more aggressive, SPY averages a next-day gain of .14% (20 up, 14 down).

In other words, relatively bearish sentiment from options traders during a large three-day rise has led to a correction the next day. Relative optimism among options traders during a three-day advance has carried over to greater strength the next day.

Sometimes, I guess, a true contrarian has to fade even a contrary indicator.