This is significant because it shows how some critics of contrarian investing will often point to the various instances of speculation and assume that it is contrarian investing. In some cases the psychology of consumers can become so extreme, that the definition of what is speculative expands greatly. As a result, using contrarian investing in conjunction with other indicators / tools can help prudent investors and traders, be able to identify when the market condition are becoming more extreme.
Contrarian Indicators and Tools
When using the different contrarian indicators / tools in conjunction with one another, you can begin to see how this strategy can be used, to effectively determine if the market conditions are overbought or oversold. There are number of different tools that can be utilized to indentify major changes that are occurring in the trend of a stock or the market averages. These would include: headlines within the mainstream press, the different put / call ratios, ISEE sentiment indicators, the VIX, the VXN, investor intelligence surveys, short interest and correlation with what is being seen with the industry or the major market averages around world.
When looking at the first tool that can be used, the headlines within the mainstream press, it is clear that this can provide a reading as to the overall mood of the investing public. Where, the press will report on those issues / situations that are important to the public, as they will talk about the various views on what is taking place. To illustrate the greatest amount of emotions, a snappy headline will appear to convey this feeling. If this happens consistently enough, many contrarians will use this as one of the tools to confirm if the investing public is to pessimistic or optimistic. An example of this can be seen during the summer of 1982, when many analysts and economists were predicting that the Dow Jones Industrial Average was going to 500, while the economy was heading into a major economic depression. Where, many headlines from across the country would say, "IMF seeks to calm jittery bankers. Mortgage delinquencies hit the highest level since 1965. De Deers reports worst the period since the 1930s."
What this shows, is that all of these different headlines that were seen during the summer of 1982 would indicate a major reversal that was getting ready to occur. Where, the markets would identify a major change that was taking place in the trends of the major market averages around the world. An example of when the markets have become overvalued; can be seen during the summer of 1987 with the common headlines saying, "Chrysler reports best quarter ever. Stampede for stocks becomes a scramble. The bulls are coming."
What this shows is that the headlines during the summer of 1987; would highlight the overall atmosphere of greed that was encompassing the markets. As a result, it would only be a matter of time until a major reversal would take place. Where, both examples illustrate how using the headlines from the popular press can be one way of indentifying the overall mood of investors and the general public. This is one of the first steps to knowing if the markets are overbought or oversold.
The Put Call Ratios
The put call ratio is when you are looking at the total amount of open puts to open calls that are trading on the Chicago Board of Options Exchange (CBOE). To fully understand how the put call ratio works requires examining the purpose of options. Simply put, an option is a contract that is giving the owner of a specific stock or security the right to buy or short, a particular investment at a particular price. A put is when an investor will purchase an option that requires the value of the underlying investment to decline. The way it works is the investor who purchases a put, has the option of shorting the stock at a particular price. If the price of the stock declines beyond the price that owner agreed to when purchasing the option (the strike price), then the option has seen an increase in value. While, a call is when an investor will purchase an option that requires the value of the investment to increase. Like with a put option, if the value goes beyond the strike price, then the call will see a significant appreciation in value.
However, if the option does not move beyond the strike price by the time it expires, then it is worthless. The risk that the investor faces is: the amount that is paid for the right to buy or short a particular investment called the premium. Depending upon the time frame to expiration and the value of the stock in relation to the strike price, this will determine if the value of the premium is increasing or decreasing. The put call ratio can be used as a way to gauge the overall emotional sentiment of the crowd, where high amounts of open put or call buying can be used to show how optimistic or pessimistic investors are looking forward. There have been a number of different studies that were conducted on this subject, with the most notable being: one that was conducted by MIT called, the Information in Option Volume for Future Stock Prices. Where, the author found that following the put call ratios of the various stocks are: an accurate indicator of the emotionalism that is being seen from the crowd. They then wanted see what the results were of those stocks that had low put call ratios in relation to the performance of the stock. What they found, was those stocks that had low historical amounts of open put or call interest from the general public outperformed the major market averages by 1% within one week.
This is significant because it underscores how looking at total amounts of put or call buying, can help investors to have another tool to measure the emotionalism of the crowd. For example, a study of the effectiveness of the put call ratio took place in Japan following the Nikki 225, using the put call ratio as the sole indicator to make investment decisions. The authors of the study found that when the put call ratios falls to extreme levels, they were an excellent indicator in predicting the reversal that would take place in the Nikki.
This is important because using this information along with the previous study that was conducted on the put call ratio, highlights how this tool can be used to determine if the markets are becoming overbought or oversold. The reason why this has been shown to be effective is: it helps to identify extreme changes in the forces of supply and demand. Where, if the prudent investor is using this tool to identify extreme price irregularities, then the odds are high that some kind of reversal is imminent.
Put Call Ratio Tools
Thee are a number of different tools that traders and investors will use to determine if the markets are overbought or oversold to include: the CBOE equity put call ratio, the CBOE index put call ratio and the CBOE total put call ratio. The CBOE equity put call ratio is when you are looking at the total amounts of puts and calls that are traded on a particular stock, over a period of time. It will trade as one single indicator that will show the lows and highs of the total amounts of put call buying that are occurring.
When the put call ratio has reached extreme points, it is a good sign that the markets are about to make a major reversal. For example, in February 2008, the CBOE put call ratio would reach a one year high. This would signal that many investors were optimistic about the future of the economy.
At which point, it would only be a matter of time until a major reversal in the trend would take place. This is significant because it underscores how the use of this tool along with other contrarian indicators will help to provide, better insights as to if the stock / markets are overbought or oversold. In general, when the equity put call ratio rises to 1.0 this is a bullish sign, which means that investors and traders in the stock have become to fearful. At which point, many contrarian traders and investors will begin purchasing the stock long or they will buy the call options. When you see a reading of .5 or lower, this is a sign that the price of the stock could be overbought (bearish). Once this kind of situation is observed, it is advisable that investors / traders tighten their sell stops or begin purchasing put options.
The CBOE Index Put Call Ratio
An index put call ratio is when you are measuring the total amount of open puts and open calls that are trading on the various indexes.…