This article appeared in Barron's Dec 19, 1983
For Stock Market Swingers
Two Indicators Help Catch Instant Shifts in Trend
By JIM NISSEN
It used to be that only a few large traders and institutions paid close attention to the stock market's intra-day swings; the investment horizon of most dabblers in stocks stretched a lot further. But today, with the profusion of new options, futures, options on futures, and other hybrid trading vehicles, there are literally thousands of traders who don't fret over where the Dow or the S&P are going next month, or even next week. This new breed cares only where the market's headed in the next hour. And with good reason: a 20-point drop in the Dow may produce a $100 profit - or a total loss - on a $50 investment in major market index puts, while even much smaller moves can also produce hefty gains - or losses - over lunch on the highly leveraged vehicles. It's Wall Street's equivalent of a racetrack's two-dollar window. And it can be just as risky.
To try to better the odds, this new breed of speculator often turns to short-term market-timing tools; new technical indicators like two I've devised: The Market Sentiment Barometer, which signals whether a market is overbought or oversold, and the Nissen Contrary Index, which gives short-term bullish or bearish readings.
To use them, you'll have to know a little - actually very little - about options, simply that (1) the price of call options - which provide the right to buy a stock or stock index at a certain price - moves up when the market goes up, and (2) the market price of put options - which provide the right to sell a stock or stock index at a certain price - moves up when the market goes down.
You''ll also need a familiarity with the market sentiment theory. It, simply put, contends that when the majority of investors are bullish, a top is reached. (If most are really bullish, they've already bought their stock - who's left to buy from them?) Conversely, if the majority is bearish, that's the bottom, because most investors have already done their selling. It's a contrarian view of the market - when most people are bullish, the averages should go down; when most are bearish, they should rise. And it's a theory that, I maintain, is equally valid for the short-term (days) and quick-term (hours) as it is for the long-term (years) and intermediate-term (months).
How can we find out how many bears and how many bulls are around at any given time? Logically, heavy call activity is associated with being bullish, and heavy put activity is associated with being bearish. This intuitive knowledge is confirmed by the records of numerous longer-term indicators developed by brokerage firms and investment advisers. Short-term, however, the evidence has been mixed.
In September, 1982, I began my quest for a really reliable short-term contrary indicator by recording, on the hour, the total volume of calls and puts traded on the option exchanges as reported by the Dow Jones News Service. Sure enough, excessive call volume usually occurred at or near short-term market peaks, while excessive put volume most often was generated at or near short-term market bottoms, confirming the market sentiment or contrary theory.
A simple formula - the volume of calls traded, divided by the volume of puts traded - provided a measure of the number of bullish or bearish participants in the options market at any given moment. If the market had been dropping for several hours, and the formula showed excessive put activity, the market should have turned up and vice versa. However, like so many market-timing tools, it was great when it worked, but when it didn't - oh, brother! All too frequently, an increase in call trading preceded a vigorous market advance. Equally bad from a technician's point of view, market declines often were preceded by an increase in put trading. Did this blow the contrarian sentiment theory? I was determined to find out.
A new phase in my search began on March 14, 1983, with the introduction of the CBOE 100 (now the S&P 100) options. I started recording the price, in addition to the volume., of every S&P 100 call and put option traded. Initially, this consisted of only six options: calls and puts on strike prices 150, 155 and 160, but now strike prices range from 145 to 180. The market price for each strike is different.
For example, with the S&P 100 at a168.20, the 150 call might sell for $1,850; the 160, for $950; and the 170 call, for $200, while the 180 put might sell for $1,250; the 170 put, for $350, and the 160 put, for $25. Oh, sorry! I promised you didn't need to know all this. Just keep in mind that there are several call and put options on the S&P 100, each of which has a different market price.
By multiplying the price times the volume for each option and then summing the results, I obtained the total amount of dollars traded in calls and puts. From this, I've constructed a Market Sentiment Barometer that I thing is the best short-term overbought/oversold oscillator available. It measures not the volume of puts and calls, but the dollars in them. The idea is that a $25 option shouldn't be measured equally with a $1,850 option. The total of dollars flowing into puts and calls is a much more accurate measure of bullish and bearish sentiment than the mere volume of the contracts.
Thus, we generate a buy signal if, for any hour, there is more than 2½ times the dollar activity in puts as there is in calls. A sell signal occurs if, for any hour, there is more than 2½ times the dollar activity in calls as there is in puts.
From Aug. 15 through late November, the Market Sentiment Indicator flashed 14 buy signals. On average, over the next six trading hours, the S&P rose 1.93 points (the equivalent of 14½ points on the Dow Jones Industrial Average). Over the next 18 market hours (three days) the S&P's ascent averaged 3.15 points (24 points on the DJIA). There was no market advance following two of the 14 signals. In fact, the market went lower.
In the same span, there were 18 sell signals. The S&P 100 fell an average of 1.39 (10½ DJIA points) during the next six trading hours. Over the next 18 trading hours, the S&P dropped an average of 2.43 points (18½ Dow points). After four of the 18 sell signals, the market rose.
In short, the indicator correctly anticipated market movement over 80% of the time. Some words of caution: These indexes have very short histories, and thus the sample used for my analysis is relatively small. There's no guarantee that the indicator will perform as well in the future.
After computing the Market Sentiment Barometer for several weeks, I began to notice a strange but consistent pattern. Increased volume in high-priced options tends to be a contrary indicator. But higher volume in inexpensive options usually is a leading indicator. Thus, before advances, volume typically increases in low-priced calls and high-priced puts. And before market declines, volume increases in low-priced puts and high-priced calls.
In other words, excessive buying in high-priced calls portends the market soon turning against the bulls in the short run. Contrariwise, excessive demand for cheap calls indicates the market will soon move up. It's an amazingly consistent pattern. Why?
The small-dollar option buyers are, by and large, the scalpers, floor traders and market makers who are aggressive risk-takers. They are the first to "sense" the market's overbought or oversold condition and act accordingly. The big bucks option buyers, on the other hand, are trying to position themselves to take advantage of a major upswing. They act only after they see that "everything is in gear" for the anticipated rise. Unfortunately for them, that usually is near the end of a short-term bull move.
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Excessive buying of high priced calls portends the
market soon turning against the bulls, short run.
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My final step was to design a way to measure this pattern of behavior. Lots of computer runs analyzing average strike prices, exponential smoothing of strike price volume for each option, in- and out-of-money volumes and other technical exotica produced some interesting statistics, but nothing straight-forward enough for everyday use.
Then, I decided simply to subtract the put and call volume ratio I'd started with from the dollar ratio in puts an calls - the market Sentiment Barometer. (To make the calculations just a mite more complex but the oscillations of the index smoother, I also convert the ratios to logarithmic form.) This produces a reading on the prices of options being traded, that I modestly call the Nissen Contrary Index.
Based solely on the relationship, or ratio, of the price of calls to the price of puts, the Nissen Index should go higher when the market rises and lower when it sinks. Most of the time, it does. But when it doesn't, the index produces bullish or bearish signals.
If the market is moving up, and the index moves down, that divergence means there's been an influx of expensive puts and cheap calls - in other words, a bullish signal. If, on the other hand, the market is dropping and Nissen Contrary Index moves up, the action's been in high-priced calls and cheap puts, and that's bearish.
Specifically, a bull move is signaled when the Nissen Contrary Index goes below its most recent low, while the S&P 100 is heading higher. It's bearish when the NCI tops its most recent high, while the S&P 100 is traveling south (see chart). Since Aug. 15, the NCI has given 16 bullish signals, the market went lower. After three of the bearish indications, the market went higher. After the buys, the S&P 100 continued to rise an average of 2.18 points (16.5 points on the DJIA) within the next 18 market hours. After the sells, the S&P 100 lost an average of 1.76 points (13 Dow points) within the next 18 market hours.
To track the index yourself, you'll need access to the price and volume on the Standard & Poor's 100 Options each hour during the market day, and a notepad, a calculator and graph paper. First make up two forms, one for the raw data as you collect it and the other as a worksheet. Title your columns as illustrated. Use the near-term option series on the S&P 100. And remember, be consistent when recording data.
Start by computing the market Sentiment Barometer. Find the total dollars in calls by multiplying the price times the volume for each call option. Total and record that number on your worksheet. Do the same for puts. The, divide the smaller dollar amount by the larger. Next, find the log of that number on the accompanying conversion table, and record it. If the dollars in calls are greater than the dollars in puts, the dollars log is positive. If put dollars are greater, the log is negative. This figure is the Market Sentiment Barometer, and it will oscillate from a very oversold -10 to a very overbought +10. (My computer chose the logarithmic conversion factor so that it would take four times the activity in calls over puts, say, to get the same extreme bearish reading.)
To figure the volume ratio, total the number of calls traded, and do the same for puts. Record those sums. Then, divide the smaller number by the larger. Next, find the log of that number and write it down. If the number of calls is greater than the number of puts, the log is positive. If the number of puts is greater than the number of calls, the log is negative. It, too, oscillates between plus and minus 10.
To compute the Nissen Contrary Index for any hour, merely subtract the volume log from the dollars log.
After you've done your calculations - which look harder than they are - it's time to evaluate what they mean. Graph the S&P 100, the Market Sentiment Barometer and the Nissen Contrary Index. Then, look at what you've come up with, noting particularly that:
A reading of +6.6 or higher on the Market Sentiment Barometer for any hour indicates an excessively bullish mood.
Look for divergences between the S&P 100 and the Nissen Contrary Index. If the market moves up, and the NCI moves down, that's bullish. If the market drops lower, and the NCI moves higher, that bearish. Longer-term divergences are more significant than brief ones.
The best buy signals occur after the Market Sentiment Barometer has registered a -6.6 or less and the market makes an hourly low above its previous one, while Nissen Contrary Index moves lower. The most profitable sell signals occur after the Market Sentiment Barometer has registered a +6.6 or better and the market makes an hourly high below its most recent one, while the Nissen Contrary Index moves higher.
The Nissen Contrary Index is valuable in determining whether the current trend is likely to continue. With the market heading upward, lower readings on the Nissen Contrary Index predict even higher prices. With the market pointing south, higher readings on the Nissen Contrary Index forecast even lower prices.
LOG CONVERSIONS
SMALL+LARGE LOG SMALL+LARGE LOG
1.000 = 0 .50 = 5.0
.95 = .4 .45 = 5.8
.90 = .8 .40 = 6.6
.85 = 1.2 .35 = 7.6
.80 = 1.6 .30 = 8.7
.75 = 2.1 .25 = 10.0
.70 = 2.6 .20 = 11.7
.65 = 3.1 .15 = 13.7
.60 = 3.7 .10 = 16.7
.55 = 4.3 .05 = 21.7
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