Index Option Trader

A Quick Lesson In Mathematics & Statistics: Part 2

As promised, this is Part 2 of my previous entry. In terms of post-capitulation market dynamics, there are a number of events that happen following an exhaustive sell-off. First off, buyers “at the bottom,” slowly and cautiously begin to buy stock. Unsure that a bottom has been formed, many investors are hesitant to come back in. Slowly, but surely the market begins to lift even with looming economic risks and uncertainties. This is classically what has come to be known as the wall of worry. As investors come back in, natural resistance points usually are met with selling pressure. Investors must deal with everything from headline to geopolitical risk on the way back up, as the smallest bit of bearish news will bring down the market once again, hence the “worry.” Market prices than usually head for the next point of natural resistance, or point of equilibrium, at the linear regression price level.

What is interesting to note is the sentiment indicators that usually do a good job of projecting these bottoms, or reversal points. Indicators like the CBOE Put/Call Equity Ratio can be used as a contrarian indicator to signal a reversal point. Usually any reading over 1.00 indicates that more puts are being bought than calls, and any reading below 1.00 signifies that more calls are being bought than puts in the market. For example, a reading high above 1.00 is usually indicative of a coming rally, while a reading far below 1.00 is usually indicative that a top as been reached and a sell-off will typically ensue. It is important to stress that using the Equity ratios are far more representative of true market sentiment, versus the Index ratios. The Index ratios are a bit skewed due to the fact that many fund managers hedge their portfolios with index products (usually puts), which causes the Index ratios to be skewed (a reading in the Index ratios of 0.80 is closer to a ‘neutral’ reading). This a a great indicator to monitor on a daily, or weekly basis to gauge market direction. CBOE Put/Call Equity Ratio figures can be found here: http://www.schaeffersresearch.com/streetools/market_tools/cboe_eqpcr.aspx

I also wanted to note that the whole talk about a the international market ‘decoupling’ effect is flat out not true. The old adage that ‘if America sneezes, the whole world catches a cold’ still remains true to some degree. During the tumultuous sell-off in the beginning of the year in the US markets, the European and Asian markets showed no signs of immunity to carnage at home. Looks like these markets, actually more than ever, are dependent on the US economy.