Successfully trading the capital markets goes well beyond having a good idea. There will be many times where you are right about the direction of a market but completely wrong about your timing. One of the problems that most traders experience is that the markets can be irrational for a period that is longer than most people are solvent. So it is important that you understand that you not only need to be right about the direction, but you also need to be right about your timing.
Now determining the exact timing is very difficult so you have to give yourself some leeway to make trades that are not going to break your bank if your timing is not perfect. There are a number of tools that you may use to help you with your timing including using sentiment. Sentiment looks at the confidence displayed by market participants and determines if there is complacency or fear. Whether greed has infiltrated a specific security or traders are looking to quickly exit.
There are a number of ways to measure sentiment. The options markets help provide a background for trader sentiment. Fear and greed are incorporated into the options market which is reflected by the premiums embedded into each option.
It is helpful to understand the basics surrounding options. There are two types of options, but many types of strategies that may be employed using options. A call option is the right but not the obligation to purchase an asset at a specific price on or before a certain date. A put option is the right but not the obligation to sell an asset at a specific price on or before a certain date. The price at which the buyer and the seller agree that the underlying asset can be bought or sold is called the strike price and the date when the options expires is called the expiration date. Options prices are referred to as premiums, which is the amount paid to own an option. To price an option, a trader would use an option pricing model which incorporates many inputs including implied volatility.
What is implied volatility? Implied volatility is how much market participants think a specific security will move over the course of a year. For example, if the implied volatility on crude oil prices is 40%, then traders believe it will move 40% either higher or lower over the course of the year. Generally, the larger the number, the higher the premium incorporated into an option price. Which in turn make the price of an option more expensive.
When markets are complacent, implied volatility is generally low, and premiums on a relative basis are low. When fear grips a market, implied volatility usually shoots higher, making the price of options higher. Many traders like to use implied volatility as a gauge of sentiment.
A great example of sentiment using implied volatility can be seen using the OVX oil implied volatility index. This index measures the “at the money” implied volatility for WTI crude oil prices. The gauge can help a trader determine price inflection points in oil prices. For example, when the OVX was at its lows near 29% in June it coincided with market complacency when oi prices where near $80 per barrel and signaled a turning point for prices. Conversely when the OVX hit its recent highs near 80% in February it coincided with an inflection point where oil prices were near its lows and signal an eventual rebound in oil prices.
Another type of options sentiment indicator is the ‘total put’ versus ‘call open interest’. When the number of puts on a relative basis outnumber the number of calls, the market is heavily weighted toward lower prices. It can be calculated by determining the total put option open interest of all strikes and months for the underlying security divided by the total call open interest all strikes and months for the underlying security. When call open interest is higher than put open interest the ratio values are less than 1. This can be considered too as a contrary indicator.
If you are looking for a shorter term sentiment indicator, you may use volume. A sentiment indicator can calculate todays total put volume for the underlying security divided by todays total call volume for the underlying security. When call volume is higher than put volume it generates ratio values less than 1, which is a contrary indicator.
Since timing the market can be a difficult endeavor it is important to try to find some tools that may help you enter the market at the best possible level. Sentiment may be an important mechanism that will help you get into the market at an appropriate time.
