Sentiment Analysis Tips
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Open Interest
To analyze stocks, we often use option open interest as a means of measuring the relative levels of investor optimism and pessimism. Open interest is the number of outstanding contracts on an option class or series. Open interest will increase by one contract when a buyer enters a new long position while the seller is entering a new short position. Open interest will decrease by one contract if a buyer is closing an old short position and the seller is closing an old long position. And open interest will stay the same if:
>> a buyer is entering a new long position while the seller is simultaneously closing an old one, or,
>> a seller is establishing a new short but the buyer is simultaneously closing an old position.
Put/Call Ratios:
We have found that using option open interest data in the form of put/call ratios is one of the better ways to quantify sentiment. Each stock's put/call ratio behaves differently and has its own particular timing implications. The analysis can be taken a step further by combining the open interest of all the stocks in a particular industry to form a composite put/call ratio for the sector. We use put/call ratio analysis to gauge whether a stock or sector is poised for a rally based upon large amounts of potential buying strength, or vulnerable to stalling out due to a lack of cash available to push it higher. High put/call ratios are often indicative of excessive pessimism and thus of large amounts of money on the "sidelines." Conversely, low put/call ratios indicate a point at which there is so much optimism that very little money is left to push the stock or index higher.
When gauging sentiment, we're primarily interested in the convictions displayed by the speculative public. Our research has shown that a contrarian view of public (rather than institutional) sentiment often proves to be a more reliable predictor of market movement. To collect options information that is more likely attributable to these speculators, we focus on the front three months of options data, which is where the small speculators tend to gravitate. By comparing the current put/call open interest ratio to previous readings for that stock, we can accurately gauge relative levels of investor optimism and pessimism. This is extremely important because we have found that the absolute ratio readings can vary substantially from stock to stock. Thus, comparing a stock's ratio to previous ratios sets up an "apples to apples" comparison that provides a truer picture of relative sentiment.
The manifestation of this analysis is an indicator we call the Schaeffer's put/call open interest ratio, or SOIR. This indicator represents a ratio of open puts to open calls on only those options due to expire over the following three months. Each daily SOIR reading is then compared to all other readings over the past year to develop a percentile rank. Higher percentiles indicate relatively more pessimism, while lower percentiles suggest optimism. Thus, a rank in the 90th percentile would mean that only 10 percent of all SOIR readings over the past year were higher, or more pessimistic. This suggests a relatively high level of negative sentiment, which can have bullish implications for a stock displaying strong fundamentals and technicals. The opposite argument can be made for a low percentile ranking, which can suggest a stock is potentially overextended and vulnerable to a sell-off due to heightened expectations.
Open Interest Configuration:
Along with put/call ratios, another way to use open interest to analyze sentiment on individual stocks is to examine the "open interest configuration" using front-month option data. The open interest configuration of a stock is simply the number of open puts or calls at the various strike prices and can be illustrated by plotting a chart with adjacent call and put bars representing the open interest at every strike price (Schaeffer's Daily Sentiment provides current and historical open interest configuration charts for all optionable equities). This approach has proven effective in determining possible resistance and support levels. How?
Option strike prices are usually round-number levels that tend to serve as support or resistance, as buyers view pullbacks to such levels as good entry points for long positions or potential closeout points for short positions. Sellers, on the other hand, look to rallies to round numbers as opportunities to exit long positions or to establish short positions. The fact that there may be significant option open interest at strike prices corresponding to these round number price levels serves to accentuate their significance as support and resistance.
For example, a large amount of call open interest can define a point of extreme market optimism, which usually coincides with the depletion of buying strength. When this strength has been depleted, it takes less selling activity to change the stock's direction. Also, those who sold these options to speculative investors may buy the underlying stock to balance their bearish positions from selling the options. These long positions will ultimately be sold when the options expire or the call buyers unwind their positions. Moreover, call sellers can become a very significant factor as the options approach expiration, as they generally own stock that they can sell to create overhead resistance.
The opposite would apply to puts. A large amount of put open interest can reflect a level of extreme pessimism toward the stock, which usually coincides with a lack of selling strength. Put sellers may short the stock to balance their bullish position and these shorts must eventually be bought back. Put sellers who do not hedge their positions will try to support the stock as it approaches the strike that they sold to protect themselves from losses.
Mutual Fund Flows
A sentiment indicator that we monitor each day is provided by the Nova and Ursa funds from the Rydex Series Trust. The Nova fund is designed to have a target beta of 1.5. In other words, using shares of equities, stock index futures contracts, and options on those securities and futures, the fund has a target performance benchmark equal to 150 percent of the S&P 500 Index (SPX). Traders who invest in this fund are considered bullish on stocks. The Ursa fund is designed to provide a performance inverse to that of the SPX by using a combination of short selling and options on stock index futures. Investors in this fund are considered bearish on stocks.
We can get an accurate view of the sentiment picture by comparing the amount of assets in each fund. Specifically, we divide the total assets in the Nova fund by the total assets in the Ursa fund to arrive at a Nova/Ursa ratio. A high Nova/Ursa ratio indicates an extreme amount of optimism (everyone investing in Nova) and a low Nova/Ursa ratio indicates an extreme amount of pessimism (everyone flocking to Ursa).
In response to the huge rise in popularity of the technology sector in late 1998 and 1999, Schaeffer's Investment Research added the Rydex OTC/Arktos ratio to its arsenal of sentiment indicators. The OTC is a bullish fund that follows the Nasdaq 100 Index (NDX). In contrast, the Arktos fund is allocated so that it provides a return opposite that of the NDX. Similar to the Nova/Ursa ratio, a high reading on the OTC/Arktos ratio means that investors are optimistic toward the market and a low reading shows that investors are pessimistic toward the market's future.
Cover Stories Effect on Stocks
Magazine cover stories are a favorite sentiment indicator at Schaeffer's Investment Research, as they work exceedingly well to illustrate our contrarian philosophy. The simplified tenet of cover-story evaluation is that when a stock becomes hot news (either on the bullish or the bearish front), it could mean change is on the way.
Periodicals are in the business of maximizing sales of each issue. To achieve this goal, editors will often jump on the "hot" topics of the day for their cover stories. As Bernie Schaeffer recently put it, "When a financial trend is featured on a magazine cover, the chances are that this trend is already:
>> Widely known
>> Universally accepted
>> In place for a decent length of time or very significant in magnitude."
If the latest issue of Forbes, BusinessWeek, Barron's, or any financial news magazine features a cover story decrying company XYZ, it could very well mean that the worst is over for the shares. In contrast, an article touting the benefits of a particular company or fund could imply that it is overloved. Even more telling is when a more generalized publication (such as Time, Newsweek, People, etc.) devotes its cover to an investment-related issue.
When the story is reaching such a broad base of the reading public, it is likely old news. That is, by the time a story has become so mainstream that it lands on the cover of a major news publication, everyone who will be taking investment action based upon the news will likely act very soon. The news itself will quickly become outdated if not erroneous.
It is important to note that these publications are not lacking in quality content. The contrarian benefit to these cover stories is simply a case of stock prices often discounting news and not following it - the so-called "buy on the rumor, sell on the news" mentality.
Our Research department has been tracking cover stories and the resultant effects for several years. We typically look at stock performance over a three-month period following the release of the magazine. The results since late 1998 are shown below.
Cover Type: Bearish* Bullish**
No. of Covers: 12 38
5-day Return: 4% 0%
10-day Return: 2% -1%
1-month Return: -1% -3%
2-month Return: 7% -3%
3-month Return: 5% -7%
* Bullish Implications ** Bearish Implications
Implied Volatility
Volatility reflects the propensity of the underlying stock to fluctuate either up or down. Premiums for at-the-money options are directly proportional to the expected volatility of the underlying stock. Implied volatility is the assumption of a stock's volatility that helps determine an option's price. Since all other factors in the options pricing model (stock price, strike price, time until expiration, interest rates, and dividend status) are assumed to be known, the implied volatility is calculated last as a "plug factor" after other options pricing components are incorporated.
Implied volatility numbers are a measure of the "relative" cost of an option and are loosely based on the actual, or historical, volatility of the underlying security. In essence, implied volatilities are driven by market expectations of the underlying stock. For example, let's look at a stable blue chip stock (A) and a newly issued technology stock (B), which are both priced at $50 per share. If the price of an October 50 call option is $2 for stock A and $4 for stock B, speculators are anticipating that stock B's price will fluctuate more than stock A. As a result, the stock B option has a higher implied volatility.
To predict future market moves we must examine the implied volatilities for the underlying market on a relatively wide scale. The Chicago Board Options Exchange Market Volatility Index (VIX) has historically been an excellent barometer for the relative level of premiums that options traders have had to pay. The VIX gauges expected market volatility over the next 30 calendar days by calculating a weighted average of the implied volatilities of eight OEX calls and puts that have an average time to maturity of 30 days. Although their trading volume has declined, OEX options are still among the most liquid in today's market. Therefore, the implied volatilities of OEX options are the most accurate measure of the broader market's volatility, and, consequently, will enhance our ability to more accurately predict future market movement.
The VIX's reaction to a short market pullback is an excellent indicator of how market participants are currently reacting to the market and what they expect will follow. If market weakness is met with an increased demand for puts, the VIX will spike upwards. Such spikes are a telltale sign of fear in the market - a very healthy and bullish view for proponents of Expectational Analysis®, as speculators will tend to buy puts after they have sold out of their long positions. This often signals an end to short-term selling pressure. If the VIX does not increase on a pullback, it signals that the public is meeting the market downturn with complacency and has expectations of a quick recovery. In these cases, there is often more downside movement to follow. As such, the VIX plays a key role in our ability to predict future market performance.
Extreme high and low VIX readings can provide good contrarian signals, though it actually doesn't matter where the reading lies on an absolute basis if it is at an extreme relative to its recent readings. Buy signals often occur as the VIX reverses lower after an extreme peak, while sell signals occur as the VIX moves higher off an extreme bottom.
A more recent addition to the arsenal of sentiment analysis is the Nasdaq-100 Trust Volatility Index (QQV), which was introduced at the beginning of 2001. Similar to the VIX, the QQV measures investor sentiment regarding the future volatility of the Nasdaq-100 Trust (QQQ). The QQQ approximates 1/40th of the Nasdaq 100 Index (NDX), which contains the 100 biggest names in the technology sector.
Sentiment Surveys
Surveys of the bullishness or bearishness of investors make for excellent expectational readings at extremes, as excessive bullishness means that buying has already mostly occurred and the risk of a negative surprise is heightened. If pervasive bearishness among investors exists, even bad news won't necessarily cause the market to go down any further since the selling has already occurred in advance of this news. Investors Intelligence and the American Association for Individual Investors (AAII) are two of the major sentiment polls. Investors Intelligence is a survey of sentiment taken of investment advisors on a weekly basis. The results are reported as percent bullish, percent bearish, and the percent that are expecting a correction. Edited by Michael Burke, this sentiment poll can be found at www.chartcraft.com. The AAII (www.AAII.com) polls individual investors to gauge whether they are bullish, bearish, or neutral. In addition, these polls are available each week in Barron's, and the latest Investors Intelligence poll is updated weekly in Investor's Business Daily.
Sentiment Analysis
If you watch the growing variety of business channels and/or news each day, you'll notice a number of company's using the term "sentiment" when discussing the overall market. We see this as a broad sign that companies are finally beginning to admit that there is more to the stock market than just fundamentals and technicals -- something we've been shouting since 1981. Having pioneered Expectational Analysis®, Bernie Schaeffer and his team have tested and developed many qualitative and quantitative methods to evaluate sentiment that go beyond the broad read you may hear from these firms. The distinguishing difference is that our indicators do not reflect only the overall market. Having had such a long term head start in this discipline, we've been able to develop sentiment indicators all the way down to individual stocks. Thus, we can use sentiment to play more than just market index options; we can apply this "edge" to individual stock option plays.
Put / Call Ratio
Over the years, sentiment analysis and options have each become increasingly popular in the investment community. What was once relegated to the final chapters of investment books and the occasional mention in magazines or periodicals has become a sizable industry. The amount and availability of data providers and website analysts have grown as well. The sources that use or cover put/call ratios in one form or another have become too numerous to count. The phrase "put/call ratio" is no longer descriptive enough by itself to convey to the analyst what kind of indicator it is. Different firms and analysts use different methods to dissect put/call ratio data and often apply their own unique methodologies. However, there are three ways in which option data can be segregated - type, data, and method. Nearly all put/call ratios encountered will be constructed from a combination of the following themes. When there is an excessive amount of bullish bets (call buying) made on equities, the buying strength has probably depleted. The opposite is true when there is a large number of bearish bets (put buying). This generally means the selling strength has faded. When there is an exorbitantly large number of puts compared to calls (a high put/call ratio), there are many investors who have made leveraged bets that stocks will decline. At that point, these investors have already sold a great deal of their stock positions, which means there is a lack of selling strength. In such a scenario, even slightly more buying strength will overwhelm the remaining sellers and push the market back up. This is why the overall market tends to rally following high equity put/call ratios.
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