Chapter 9
Trading with Feeling Now!
In This Chapter
Thinking in a contrary fashion
Reacting to changes in volume
Knowing how to benefit from open interest info
Using put/call ratios
Watching for signs of soft sentiment
As a contrarian thinker, my first real-life experience with contrarian market analysis was in 1990. Sure, I’d read the books and articles that tell stories about how stocks need to be sold when the shoeshine boy starts recommending stocks to you as he polishes your shoes at the airport. But, for me, 1990 was the literal proof in the pudding.
At some point in August 1990, stocks were failing in the U.S. markets, and the price of crude oil was testing the $40-per-barrel resistance level. At the time, $40-per-barrel oil was an extremely high price, even though it’s cheap compared to the $105 prices to which it eventually soared in February 2008.
Both times the rise in the price of oil to what was then a record high was caused by a war in Iraq, at least initially. The situation in 2008 was slightly different, although there were still U.S. troops in Iraq.
As I discuss in detail in Chapter 13, we live in a world full of conflict, and it’s important to keep in mind that wars and other world events affect how the psyches of investors work. As an investor, it’s important to be aware of how news items impact the market.
During the latter stages of the oil rally in 1990, a picture of an Arab man holding a gun was on the cover of BusinessWeek magazine with the headline of headlines above it: “Hostage to Oil.” That caught my eye. And sure as shootin’ that cover story appeared only a few weeks before the price of oil topped out and actually collapsed when the United States invaded Iraq a few months later.
My contrarian stance was reinforced once again by the markets in 1991. That’s when the first U.S. invasion of Iraq touched off a decade-long bull market in the U.S. stock market.
In this chapter, I take you through the major aspects of contrarian thinking and explain how to know when to use it and how to make it part of your trading arsenal.
The Essence of Contrarian Thinking
Contrarians trade against the grain at key turning points when shifts in market sentiment become noticeable. The most important aspect of contrarian thinking, though, is to be able to spot those important turning points that can lead to profitable trades. For example, a contrarian may
Start looking for reasons to sell when everyone else is bullish
Think a good time to buy is when pessimism about the markets is so thick that you can cut it with a knife
More can be made of contrarian trading than just using the prevailing sentiment in the market, because sentiment trading is inexact and can lead to losses whenever you pull the trigger too early during the cycle.
The bullish extremes reached during the buildup of the Internet bubble were unprecedented. Although traders who sold early were vindicated, they nevertheless lost a great deal of money by getting out too early. Another extreme is when the bear market in stocks ended in 2002. Traders who got into stocks during the seven-month period from June 2002 to March 2003 were whipsawed, or shaken out of positions with losses and tortured by the extremes in volatility that can happen as the final bottom of the mega bear market finally formed.
Throughout the three-year period during which the bear market in stocks unfolded, plenty of opportunities opened up to trade on the long side, meaning to buy stocks based on sentiment. But most of them proved false until the final bottom was reached.
Simply put, sentiment analysis is an inexact science and is only part of what you need to know to be a better trader. It is also a part that works better when combined with technical analysis.
This chapter helps you combine sentiment and technical analyses within your trading arsenal to lead you to better decision making.
Bull Market Dynamics
To understand sentiment and when it is most useful as a guide to trading, brushing up on the dynamics of a bull market is helpful. Because most people can identify with a bull market in stocks best, I use it as an example. Yet, the basic principles apply to just about any bull market in any commodity or financial asset.
The first stage of any bull market is when the market is sold out, and you see short covering, or the offsetting of short positions, which is based on the realization by the pessimists that the bulls are starting to charge. Still, because it’s early in the new bull market, the bears tend to hang on, usually buying put options — options that are betting on lower prices — even as they short cover. This in turn creates a nice climate of pessimism, which is reflected in an indicator known as the put/call ratio (I discuss this later in the section “Putting Put/Call Ratios to Good Use”).
This rise in pessimism, even though the bottom has been put in place, is known collectively as the “wall of worry.” The wall of worry can last a few days or a few weeks. What’s important is that at some point, if indeed the rally is strong enough to have launched a new bull run, the bears finally throw in the towel and the put/call ratios, which have risen mostly due to put option buying, start to trail off. It is at that time, when the wall of worry melts away, that the market becomes vulnerable.
Survey Says: Trust Your Feelings
Two popular sentiment surveys affect the futures markets: Market Vane and Consensus, Inc.
Consensus, Inc., www.consensus-inc.com, is based in Kansas City and it publishes Consensus weekly as a newspaper that you get in the mail or as an Internet publication. Consensus offers sentiment data on the following:
Precious metals: Silver, gold, copper, and platinum
Financial instruments: Eurodollars, U.S. dollars, Treasury bills (T-bills), and Treasury bonds (T-bonds)
Currencies: The U.S. dollar, Euro FX, British pound, Deutschemark, Swiss franc, Canadian dollar, and the Japanese yen
Soybean complex: Soybeans, soybean oil, and soybean meal
Meats: Pork bellies, hogs, cattle, and feeder cattle
Grains: Wheat and corn
Stock indexes: The S&P 500 and NASDAQ 100 stock indexes
Foods: Citrus fruits, sugar, cocoa, and coffee
Fibers: Cotton and lumber
Energy complex: Crude oil, natural gas, gasoline, and heating oil
Market Vane, www.marketvane.net, offers a similar set of measures under the name Bullish Consensus. Of the two sentiment surveys, Market Vane’s is better known, and according to its Web site, Bullish Consensus has been published on a weekly basis since 1964 and on a daily basis since 1988.
Snapshots of both surveys for stocks, bonds, eurodollars, and euro currency are available weekly in Barron’s magazine, under the Market Laboratory section or at Barron’s Online, www.barrons.com.
After you find out the market sentiment, technical analysis kicks in. A high bullish reading in terms of sentiment should alert you to start looking for technical signs that a top is in place, checking whether key support levels or trend lines have been breached, or checking whether the market is struggling to make new highs. See Chapters 7 and 8 for more details on technical analysis.
Sentiment surveys are popular tools used mostly by professional traders to gauge when a particular market is at an extreme point with either too much bullishness or too much bearishness. Their major weakness is that they’re now so popular that their ability to truly mark major turning points is not as good as it was even in the late 1980s or early 1990s. Still, when used within the context of good technical and fundamental analysis, sentiment surveys can be useful.
Other particulars that describe the sentiment surveys are that they are
Based on advisor polls that are conducted either by reading the latest publications sent to the survey editors or by telephone polling of a group of advisors.
Indirect measures of public opinion about the individual markets.
Interpreted as a measure of public opinion because they’re based on advisory opinions usually subscribed to by the public. However, market professionals traditionally considered the public to be wrong, especially at market turning points.
Check your charts and other indicators to confirm what the surveys are saying.
Avoid trading on sentiment data alone, because doing so is too risky.
Check sentiment tendencies against technical and fundamental analyses, even though it may make you a little late in executing your entry or exit trades. Making sure is better than missing a significant part of an advance if you’re long or a decline if you’re short.
Even though the sentiment surveys are not giving you textbook numbers, they nevertheless can be useful. Figure 9-1 highlights a set of key market turning points in the 2004–2005 time period.
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Figure 9-1: Key tops and bottoms in the S&P 500 from July 2004 to June 2005 were correctly called by sentiment surveys. |
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Figure 9-1 shows a good set of tops and bottoms in the stock market in 2004 and 2005. These were nearly textbook examples of how sentiment can be useful.
But, it’s not always that clear. Consider this example. The stock market began a rally in August of 2007, although Consensus had a 63 percent bullish percentage and Market Vane had a 56 percent bullish percentage near the time when the market bottomed. Usually, long-lasting bull markets are spawned by much lower readings in the sentiment surveys. These are usually near or below 40 percent bullish percentages, and are known as sentiment washouts, meaning that there aren’t enough bears around to keep prices down. Markets always follow the path of least resistance, and thus you get a rally.
The rally moved strongly into October, but by October 12, the bullish numbers were at 75 percent and 69 percent respectively. The following week saw the market start to stumble; on October 19, on the 20th anniversary of the Crash of 1987, the Dow Jones Industrial average fell over 300 points.
In fact, the market sentiment numbers in October were correct as that proved to be the top for that rally. For a stock investor with a 12- to 18-month time horizon, the 300-point down day may be seen as a long-term buying opportunity. Yet, as a futures trader, your time frame will more likely be two hours to two weeks. Had you owned stock index futures during this period, you might have taken a big loss if you hadn’t been watching a wide array of indicators, including the sentiment surveys.
Considering Volume (And How the Market Feels About It)
Trading volume is a direct, real-time sentiment indicator. As a general rule, high trading volume is a sign that the current trend is likely to continue. But consider that advice as only a guideline. Good volume analysis takes other market indicators into account. Figure 9-2, which shows the S&P 500 e-mini futures contract for September 2005, portrays an interesting relationship between volume, sentiment, and other indicators.
In April, the market made a textbook bottom. Notice how the volume bars at the bottom of the chart rose as the market was reaching a selling climax, as signified by the three large candlesticks, or trading bars. This combination of signals — large price moves and large volumes when the market is falling — is often the prelude to a classic market bottom, because traders are panicking and selling at any price just to get out of their positions.
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Figure 9-2: Volume and the e-mini S&P 500 September 2005 futures. |
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Notice how the volume trailed off as the market consolidated, or started moving sideways, making a complex bottom that took almost two weeks to form. Consolidation is what happens when buyers and sellers are in balance. When markets consolidate, they’re catching their breath and getting set up for their next move. Consolidation phases are unpredictable and can last for short periods of time, such as hours or days, or longer periods, even months to years.
A third important volume signal occurred in late May and early June as the market rallied. Notice how volume faded as the market continued to rise. Eventually, the market fell and moved significantly lower as it broke below key trend-line support.
Finally, note in Figure 9-2 that open interest (see the section “Out in the Open with Open Interest,” later in this chapter) fell during the last stage of the rally in late June, which usually is a sign that more weakness is likely. This is because fewer contracts remain open, suggesting that traders are getting exhausted and are less willing to hold on to open positions.
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The release of volume figures in the futures market is delayed by one day.
Higher volume levels steadily migrate toward the closest delivery month, or the month in which the contract is settled and delivery of the underlying asset takes place. That migration is important for traders, because the chance of getting a better price for your trade is higher when volume is better. In June, for example, the trading volume is higher in the S&P 500 futures for the September contract than for other months, because September is the next delivery month. Volume for the delivery-month contract increases for a while as traders move their positions to the front month, or the commonly quoted (price) contract at the time. Say, for example, that the volume data for June 24, 2005, shows 36,717 contracts traded in the September 2005 contract, 170 in the December 2005 contract, and 21 in the March 2006 contract. None of the other listed contracts had any volume on that day.
Limit days (especially limit up days), or days in which a particular contract makes a big move in a short period of time, can have very high volume, thus skewing your analysis. A limit up day, when the market rises to the limit in a short period of time, usually is a signal of strength in the market. Limit up or limit down days tend to happen in response to a single or related series of events, external or internal, such as a very surprising report. When markets crash, you can see limit down moves that then trigger trading collars (periods when the market trades but prices don’t change) or complete stoppages of trading.
The opposite is true when you have a big move on low volume, such as the first of the last two bars pictured in Figure 9-2. On the day of the first break of the rising trend line, volume was lower than in the prior few days. On the second day of selling, volume rose, suggesting that more trouble was coming.
Put the current volume trends in the proper context with relationship to the market in which you’re trading, instead of thinking about hard-and-fast rules. It’s important to note that trends tend to either start or end with a volume spike climax (typically twice the 20- or 50-day moving average of daily volume).
Remember the differences in the way that volume is reported and interpreted in the futures market compared with the stock market.
Check other indicators to confirm what volume is telling you.
Ask yourself whether the market is vulnerable to a trend change.
Consider key support and resistance levels.
Protect your portfolio by being prepared to make necessary changes.
Out in the Open with Open Interest
Open interest is the number of active contracts for any given security during any trading period. It is the most useful tool for analyzing potential trend reversals in futures markets.
A more formal definition is this: Open interest is the total number of contracts entered into during a specified period of time that have not been liquidated either by offsetting transactions or by actual delivery. Open interest applies to futures and options but not to stocks.
Open interest
Measures the total number of short and long positions (shorts and longs)
Varies based on the number of new traders entering the market and the number of traders leaving the market
Rises by one whenever one new buyer and one new seller enter the market, thus marking the creation of one new contract
Falls by one when a long trader closes out a position with a trader who already has an open short position
The exchanges publish open-interest figures daily, but the numbers are delayed by one day. Therefore, the volume and open-interest figures on today’s quotes are only estimates.
Open interest is one of the most useful tools you can have when trading futures. Even though the figures are released with a one-day delay, they still are useful when you evaluate the longer trend of the market.
Rising markets
In a rising trend, open interest is fairly straightforward:
Bullish open interest: When open interest rises along with prices, it signals that an uptrend is in place and can be sustained. This bullish sign also means that new money is moving into the market.
Extremely high open interest in a bull market usually is a danger signal.
Bearish open interest: Rising prices combined with falling open interest signal a short-covering rally in which short sellers are reversing their positions so that their buying actually is pushing prices higher. In this case, higher prices are not likely to last, because no new buyers are entering the market.
Bearish leveling or decline: A leveling off or decrease in open interest in a rising market often is an early warning sign that a top may be nearing.
Sideways markets
In a sideways market, open interest gets trickier, so you need to watch for the following:
Rising open interest during periods when the market is moving sideways (or in a narrow trading range; see Chapter 8) because they usually lead to an intense move after prices break out of the trading range — up or down.
When dealing with sideways markets, be sure to confirm open-interest signals by checking them against other market indicators.
Down-trending price breakouts (breakdowns). Some futures traders use breakouts on the downside to set up short positions, just like commercial and professional traders, thus leaving the public wide open for a major sell-off.
Falling open interest in a trader’s market. When it happens, traders with weak positions are throwing in the towel, and the pros are covering their short positions and setting up for a market rally.
Falling markets
In falling markets, open-interest signals also are a bit more complicated to decipher:
Bearish open interest: Falling prices combined with a rise in open interest indicate that a downtrend is in place and that it’s being fueled by new money coming in from short sellers.
Bullish open interest: Falling prices combined with falling open interest is a sign that traders who had not sold their positions as the market broke — hoping the market would bounce back — are giving up. In this case, you need to start anticipating, or even expecting, a trend reversal toward higher prices after this give-up phase ends.
Neutral: If prices rise or fall, but open interest remains flat, it means that a trend reversal is possible. You can think of these periods as preludes to an eventual change in the existing trend. Neutral open-interest situations are good times to be especially alert.
Trending down: A market trend that has shifted downward at the same time open interest is reaching high levels can be a sign that more selling is coming. Traders who bought into the market right before it topped out are now liquidating losing positions to cut their losses.
Putting Put/Call Ratios to Good Use
The put/call ratio is the most commonly used sentiment indicator for trading stocks, but it can also be useful in trading stock index futures, because with it you can pinpoint major inflection points in trader sentiment. Put/call ratios, when at extremes, can be signs of excessive fear (a high level of put buying relative to call buying) and excessive greed (a high level of call buying relative to put buying). However, these indicators are not as useful as they once were because of more sophisticated hedging strategies that are now often used in the markets.
As a futures trader, put/call ratios can help you make several important decisions about
Tightening your stops on open positions
Setting new entry points if you’ve been out of the market
Setting up hedges
Taking profits
The Chicago Board Options Exchange (CBOE) updates the ratio throughout the day at its Web site, www.cboe.com/data/IntraDayVol.aspx, and provides final figures for the day after the market closes.
The sections that follow describe two important ratios with which you need to become familiar when trading stock index futures.
Total put/call ratio
The total put/call ratio is the original indicator introduced by Martin Zweig, a prominent money manager and author who was one of the few traders who sidestepped the market crash of October 1987 and made money by buying put options. The put/call ratio is calculated by using the following equation:
total put options purchased ÷ total call options purchased
The total ratio includes options on stocks, indexes, and long-term options bought by traders on the CBOE. Although you can make sense of this ratio in multiple ways, I’ve found it useful when the ratio rises above 1.0 and when it falls below 0.5. When the ratio rises above 1.0, it usually means too much fear is in the air and that the market is trying to make a bottom. Readings below 0.5, however, usually mean that too much bullishness is in the air and that the market may fall.
Index put/call ratio
The index put/call ratio is a good measure of what futures and options players, institutions, and hedge-fund managers are up to. When this indicator is above 2.0, it traditionally is a bullish sign, but when it falls below 0.9, it becomes bearish and traditionally signals that some kind of correction is coming. Because these numbers are not as reliable in the traditional sense as they used to be, please consider them only as reference points, and never base any trades on them alone. Don’t forget that put/call ratios need to be correlated with chart patterns.
In June 2005, the CBOE index put/call ratio was high during the period from June 17–23, which included an options expiration week. During those five trading sessions, three readings of the index put/option ratio were above 2.00; the highest reading of 2.75 occurred on June 21. If you had taken these numbers at face value, you probably would have gone aggressively long, expecting a likely rise in stock index futures. Unfortunately, you would have been wrong!
On June 23 and 24, the Dow Jones Industrial Average lost more than 290 points, and the rest of the market got clobbered, too. Hindsight obviously tells you that in this case, the rising put/call ratio was a signal that somebody, or a group of people somewhere, was aware of information that something interesting might happen that could shake the markets.
Common knowledge tells you that many people with lots of money have access to information to which you and I would never be privy and that we’d never be able to gather. The job of the trader is to look for signs that something may be brewing.
And there it was — on Thursday, June 23, China’s third largest oil company, CNOOC, bid $18 billion to purchase American oil company Unocal. The political firestorm kicked off by this event certainly gave players a reason to sell stocks.
Check the put/call ratios after the market closes. The CBOE usually updates the numbers by 5 p.m. central time.
Favor thoughts of dramatic market reactions over thoughts of where the market is headed when you see abnormally high or low put/call ratios. Be ready to handle dramatic changes.
Immediately look for weak spots in your portfolio whenever abnormal activity occurs in the options market. Abnormal activity should trigger ideas about hedging.
When you see abnormal put/call ratio numbers, consider the following:
Tightening stops on your open stock index futures positions.
Look for ways to hedge your portfolio. Some hedges include option strategies, while others include buying or selling short positions in other markets, such as bonds, energy, or metals.
Reversing positions. If you have a short position in the market, make sure that you’re ready to reverse and go long or vice versa if you have a long position.
Understanding the Relationship Between Open Interest and Volume
Table 9-1 summarizes the relationship between volume and open interest. Figure 9-2 (earlier in this chapter) shows a great example of how to combine open interest and volume to predict a trend change.
Volume and open interest go hand in hand in futures trading. Generally, volume and open interest need to be heading in the same direction as the market. When the market starts rising, for example, you want to see volume and open interest expanding. A rising market with shrinking volume and falling open interest usually is one that is heading for a correction.
| Price | Volume | Open Interest | Market |
|---|---|---|---|
| Rising | Up | Up | Strong |
| Rising | Down | Down | Weak |
| Declining | Up | Up | Weak |
| Declining | Down | Down | Strong |
Note in Figure 9-2 how the market started to rally in early June. Both volume and open interest (the line coursing above the volume bars) moved up. This chart confirmed the rising trend in the E-mini S&P futures.
After June 13, however, the market started going sideways. Volume began to fade, and open interest began to flatten out. Three days before the June 24 break, open interest fell precipitously, signaling that the rally was running out of gas. Fading volume provided a great example of how smart money was taking profits and being replaced by new, weaker buyers. Likewise, falling open interest not only confirmed an impending downturn, but it also revealed that traders with weak short positions were bailing out. The market thus was losing buyers and sellers and its liquidity, which, in turn, made it vulnerable to external events, such as the CNOOC/Unocal news.
When you plugged in rising put/call ratios with falling open interest in stock futures, the result was a sign that the smart money sensed a rising risk in the market. It was preparing itself by buying portfolio insurance in the form of put options, which rise in price during falling markets. Smart money refers to large institutions, hedge funds, or individuals. They have better access to information than the market at times, and they tend to act ahead of the crowd. Sometimes they’re correct, and other times they’re wrong. In this example, they were correct.
Using Soft Sentiment Signs
Soft sentiment signs usually are out of the mainstream and are subtle, nonquantitative factors that most people tend to ignore. They can be anything from the shoeshine boy giving stock tips or a wild magazine cover (classic signs of a top) to people jumping out of windows during a market crash (a classic sign of the other extreme). These signs can be anywhere from dramatic to humorous, and they can be quite useful. By no means should you make them a mainstay of your trading strategy. But they can at times be helpful.
Scanning magazine covers and Web site headlines
Based on my 1990 experience with BusinessWeek and the top in oil prices, every time crude oil rallies, I start looking for crazy headlines, especially on the Drudge Report. The Drudge Report (www.drudgereport.com) is a Web site that can be, in my opinion, somewhat sensational, but still the old-school indicators found there can be useful.
Look for clearly sensational headlines, such as those depicting the potential end of an era, and so on. Some of the ones that appeared on Drudge in March 2008, as oil made all time highs were:‘“Bush: US Must “Get Off Oil”’ from Reuters and “Swarm of Bay Area gas price records” from the San Francisco Chronicle.
When crude oil reached a then all-time high on June 17, 2005, I scanned the covers of Time, Newsweek, and BusinessWeek. Time’s cover featured the late Mao TseTung, BusinessWeek had senior citizens, and Newsweek had dinosaurs. None of them even mentioned oil — a good soft sentiment sign that the oil market still had some room to rise.
Monitoring congressional investigations and activist protests
Another soft sign that a top may be near is what politicians and activists say or do in relation to how the markets move. So, as oil made a new high in 2005, I scanned the news for signs of senators and other members of Congress or of activists who were calling for investigations or alleging that the oil companies were price gouging.
It took a while, but by the end of June, with Congress in full swing, the attempted takeover of Unocal mobilized both sides of the aisle. Letters to President Bush were written. Hearings were held at which Fed Chairman Alan Greenspan and Treasury Secretary John Snow argued about China’s newly found role as a world power and what the circumstances would likely be. The markets worried about protectionism, as well they should — the last depression in the United States came as a result of Congress and President Herbert Hoover concocting the Smoot-Hawley tariff.
Political activity and outrage are no accident. They usually mean that the public is interested in the current set of developments. The thing is, when politicians and activists finally pick up the chant, they do so because they see some kind of advantage for their cause or their chances of being reelected. And that’s usually a sign that things are at a fever pitch, and the trend can change, possibly in a hurry.
Developing Your Own Sentiment Indicators
A hot market eventually changes trends. It gets cold. No one knows when that’s going to happen. By using sentiment indicators and confirming one with another, you can get early warnings of pending changes.When any market makes a new high, I usually go to the Drudge Report and look for the headline. If it’s sensational enough, I start being careful about that particular area of the market. Here are my favorite personal indicators:
If I start bragging to my wife about how much money I’m making in the markets, I look for reasons to sell.
When my mother tells me that I need to start watching the NASDAQ the way she did in the summer of 1999, I start to shake in my boots.
When everybody starts giving me tips, I run for the door. You can develop your own private set of indicators by monitoring your own excitement level. If you start feeling invincible, as if you’re the best trader in the world, being a little more careful is a good idea. Make a mental checklist. I always check my gut when I trade. If I’m all tied up in knots, I’m less concerned than if I’m happy as a lark, because if I’m worried, I’m awake. Mind you, don’t make yourself sick over it. If you can’t stand what you’re doing, then it isn’t for you. The key is to search for some kind of balance within yourself by keeping your eyes open, doing your homework, and comparing what’s going on in the charts with what you’re reading and hearing from others.