As a primary investor in mutual funds I am not sure how to interpret the following: 1. put/call ratio; 2. vix; 3. vxn; 4. support/resistance for exchange, i.e., Nasdaq support, resistance, channels, etc. Extremely interested in wanting to know how to understand your e-mail and use above data. (November 29, 2001)
The first three are what we call sentiment indicators. They are measures of how excited, complacent, bearish and bullish, scared or elated investors are about the market. As measures of investor emotion, they are best at flagging potential changes in market direction when they get to extremes. And they work inversely to the sentiment. For example, if investors are scared to the point of panic and are getting out of stocks, that is a signal that the market could be ready to turn back up. If investors are giddy with excitement about the market's prospects, that is a topping sign. Too far one way or the other, whether greed or fear, can indicate a change coming.
The put/call ratio measures the number of puts to calls traded in a session. It is best measured at the close. If it closes at 1.0, that means as many puts as calls traded. 0.50 indicates that for every 10 calls traded, 5 puts were traded. Why follow this? Because the majority of option traders, unlike our subscribers, are speculators, trying to buy cheap options and hit the long ball. When they get feeling too good or too scared as a whole, that can signal a change in market direction.
If they feel the market can only go up, that is an indicator that the market could be ready to drop. That usually occurs with a reading below 0.4. 0.4 indicates complacency; lower than that indicates an almost unaimous opinion among the speculators that the market can only go up. That is extreme. On the other hand, a reading greater than 1.0 on the close historically indicates that option players are scared, thinking the market is going down. They start loading up on puts, speculating on a further fall. It may take 2 or more closes above 1.0 to give a solid indication, but it has been very reliable at bottoms. The week the market reopened in September, 4 of the 5 sessions showed a put/call ratio greater than 1.0 on the close (1.21 at one point). That was massive downside speculation and fear, and the market found its bottom and turned.
Of late it has traded a lot in the 0.7 range. That is still an indication of a lot of nervousness, and we have seen it fall lower just to spike right back up on the first hint of selling. There are a lot of option players thinking the market has to fall. That is good as the market likes to climb that wall of worry.
As with all sentiment indicators, it is secondary to price and volume action. Price/volume shows us the actual buying or selling that is occurring. It is the 'horses mouth.' The sentiment indicators give us a heads up to a potential change in direction and we then have to watch the primary indicators closely. They are very useful, but we do not want to elevate them beyond their capabilities.
This weekend we will cover the other indicators in detail as well.
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