TradingAgainst

the CrowdProfiting from Fear and Greed

in Stock, Futures,and Options Markets

JOHN SUMMA

John Wiley & Sons, Inc.

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C1.jpg

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TradingAgainst

the Crowd

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John Wiley & Sons

Founded in 1807, John Wiley & Sons is the oldest independentpublishing company in the United States. With offices in NorthAmerica, Europe, Australia, and Asia, Wiley is globally commit-ted to developing and marketing print and electronic productsand services for our customers’ professional and personalknowledge and understanding.

The Wiley Trading series features books by traders who havesurvived the market’s ever-changing temperament and haveprospered—some by reinventing systems, others by getting backto basics. Whether a novice trader, professional, or somewherein-between, these books will provide the advice and strategiesneeded to help you prosper today and well into the future.

For a list of available titles, please visit our Web site atwww.WileyFinance.com.

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TradingAgainst

the CrowdProfiting from Fear and Greed

in Stock, Futures,and Options Markets

JOHN SUMMA

John Wiley & Sons, Inc.

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Copyright © 2004. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or trans-mitted in any form or by any means, electronic, mechanical, photocopying, record-ing, scanning, or otherwise, except as permitted under Section 107 or 108 of the1976 United States Copyright Act, without either the prior written permission ofthe Publisher, or authorization through payment of the appropriate per-copy feeto the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923,978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. Requests tothe Publisher for permission should be addressed to the Permissions Department,John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008.

Limit of Liability/Disclaimer of Warranty: While the publisher and author haveused their best efforts in preparing this book, they make no representations orwarranties with respect to the accuracy or completeness of the contents of thisbook and specifically disclaim any implied warranties of merchantability or fitnessfor a particular purpose. No warranty may be created or extended by sales repre-sentatives or written sales materials. The advice and strategies contained hereinmay not be suitable for your situation. You should consult with a professional whereappropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

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ISBN: 0-471-47121-6

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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For Lisa

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The efficient markets theory asserts that all financial pricesaccurately reflect all public information at all times. In otherwords, financial assets are always priced correctly, givenwhat is publicly known, at all times. Price may appear to betoo high or too low at times, but, according to the efficientmarkets theory, this appearance must be an illusion.

—Robert J. Shiller From Irrational Exuberance

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ixixix

Acknowledgments

This book could not have been written without the influence ofearlier books that explored the role psychology plays in marketprice behavior long before I took up the quest. These include JohnMaynard Keynes’s The General Theory, Charles Mackay’s ExtraordinaryPopular Delusions and the Madness of Crowds, Humphrey B. Neill’s TheArt of Contrary Thinking, Norman Fosback’s Market Logic, and Robert J.Shiller’s Irrational Exuberance, to name only a few. I am indebted to theseauthors and their pioneering work.

I want to thank Pamela van Giessen of John Wiley & Sons for giving methe opportunity to make my own contribution to this tradition, as well asLara Murphy and Jennifer MacDonald at Wiley for their professional han-dling of all my editorial concerns.

Also, I would like to express my gratitude for the superb copyeditingdone by Matthew Kushinka of PV&M Publishing Solutions, and the skillfultranslation of MetaStock code into TradeStation code by Ron Hudson.

While there were many other persons who helped me with this project,I would like especially to thank Lorie Meg Karlin of Managed Capital Advi-sory Group, Ltd. for her generous support during the final writing stages. Iam also grateful to Bertrand Desruelles, Paltamas Gordon, Lisa Hardy, andJohn Sarich for their encouragement and valuable input at various stages ofthis project.

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xixixixi

Contents

Preface xiii

Introduction xv

CHAPTER 1 Reflections of a Contrarian on InvestorPsychology 1

CHAPTER 2 Measuring “Joe Options Trader” Sentiment 7

CHAPTER 3 Will the Real Put/Call Ratio Please Stand Up? 15

CHAPTER 4 The Options Trading Crowd at Extremes 25

CHAPTER 5 Does the Entire Group of Options Traders Get It Wrong? 35

CHAPTER 6 OEX Options Traders—Is This a Smart MoneyCrowd? 45

CHAPTER 7 From Statistical Tests to Sentiment Trading System 55

CHAPTER 8 Squeeze Play I: Pulling the Price Trigger 63

CHAPTER 9 Sentiment Squeeze Play II 73

CHAPTER 10 Squeeze Play II and LEAPS Surrogates 91

CHAPTER 11 The Tsunami Sentiment Wave Trading System 97

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CHAPTER 12 Adapting Put/Call Ratios to Bond Futures 103

CHAPTER 13 Option Implied Volatility and Investor Sentiment 109

CHAPTER 14 Testing Option Volatility onEquity Indices 117

CHAPTER 15 Stock Options Volatility and Sentiment Long Waves 133

CHAPTER 16 Gauging Crowd Psychology with Short Selling Ratios 143

CHAPTER 17 Public Shorts: Still as Good as Ever as Crowd “Sentimeter” 153

CHAPTER 18 Trading Against the Advisory Opinion Crowd 159

CHAPTER 19 The Fourth Estate Crowd 165

CHAPTER 20 Postscript on Crowd Psychology in Financial Markets 175

Appendix A MetaStock Formula Language Code 179

Appendix B TradeStation EasyLanguage® Code 183

Appendix C Notes on System Testing 193

Index 199

xii CONTENTS

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Preface

In his 1954 investment book classic The Art of Contrary Thinking,Humphrey B. Neill explained that the task of the contrarian “consists intraining [the] mind to ruminate in directions opposite to general publicopinions.” In practice, this involves trading against prevailing market senti-ment of what is popularly known as the investor “crowd.”

Ruminating opposite the sentiment of the investor crowd, however, isnot a subjective exercise. Today, this approach to the markets involves theuse of objective market indicators that attempt to gauge investor and tradersentiment as accurately as possible, most importantly to identify when theyreach extremes. At extreme levels of market sentiment the market tends tobe most predictable, the best precondition for taking a trade.

After years of watching, researching, and trading the markets, I stillfind measures of investor sentiment to be my most reliable and thus favoriteindicators. I am not alone in my experiences. Many successful traders andmoney managers place special emphasis on investor sentiment gauges toinform their trading decisions. And so should you.

In this book, I explain how to understand investor sentiment data, buildcustom indicators with that data, and incorporate these sentiment indica-tors in trading systems that I have developed and tested.

While the premise of this book is that the speculative crowd tends tomisread the market at the most extreme sentiment points, some of the trad-ing systems presented here also profit from less extreme sentiment. Prof-itable trading is shown to be possible in above- and below-average bearishand bullish sentiment cycles that operate within larger sentiment waves.Whether trading on short-term cycles (or waves) or longer-term ones, how-ever, the systems tested and presented here provide powerful evidence ofthe nonrandom (thus, predictable) nature of markets.

While markets ultimately may be regulated by fundamentals, the com-mon errors and misjudgments that regularly appear in the crowd’s actions

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suggest another dimension to market price behavior is at work. It appearsmarkets become victim of the crowd’s emotions for periods of time longerthan random walk theorists (who believe that predicting future pricemovements is not possible) are willing to accept. Examples of these crowdactions are the manias found in history like the stock market bubble of the1990s, as well as short-term overreaction to news shocks. The goal of thisbook, therefore, is to develop trading systems that are capable of harness-ing profitably such emotionally charged misjudgments.

Finally, it is my hope that this book inspires you to begin your ownruminations against the crowd. The trading systems and custom sen-timent indicators presented in this book do not represent the final word on this subject. Hopefully, these will encourage you to explore similarapproaches—perhaps discovering even better ways to extract profit bytrading against the sentiment of the investor crowd.

JOHN SUMMANew Haven, CT

April 2004

xiv PREFACE

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Introduction

Ifirst discovered the power of investor sentiment indicators when Ibegan tracking daily put and call option volume during the bull marketof the 1990s. One of the most followed and reliable sentiment gauges,and one given special emphasis in this book, is the Chicago Board OptionsExchange (CBOE) equity-only put/call ratio. It began sending warning sig-nals of an impending market decline in late 1999 and early 2000, a develop-ment I conveyed to readers of my OptionsNerd.com weekly market reportat that time.

The extreme readings showed excessive bullishness that was reflectedin low CBOE put/call ratios (demand for call options had significantlyincreased relative to put options). This came on top of a palpable break-down of technical conditions in equity markets, adding weight to the argu-ment that it was time to get out. Too many call options demanded relativeto puts indicates a complacent market, vulnerable to potential distur-bances. The crowd, a term that is used in this book to refer to emotionallydriven investors with less sophistication, became too uniform in their viewof the market, believing stocks could only keep rising.

Investors or traders who expect a rise in prices purchase call options.Put options are purchased in anticipation of a fall in prices. The lack of inter-est in put options, therefore, along with the surging demand for call options(reflected in a low put/call ratio), showed a lack of concern about the poten-tial for downside stock market price movement. I need not recount the endof this story, as events that followed in 2000, 2001, and 2002 speak loudlyenough to the power and immense value of this timely indication.

Used correctly, therefore, sentiment indicators can produce excellentmarket timing signals capable of pinpointing short- and medium-termmarket tops and bottoms. In this book, I incorporate put/call ratios, as wellas other gauges of crowd psychology—option volatility, short sales, investor

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surveys, advisory opinion, and news flow—into trading systems that Ihave developed, such as Squeeze Play I and II and Tsunami Sentiment Wave,(for which I have presented MetaStock and TradeStation system code inAppendices A and B). The results establish beyond any doubt, that senti-ment, if properly harnessed, remains an excellent trading tool.

That said, the potential to deliver profits depends on the discipline thattraders bring to the game, along with the use of effective money manage-ment to handle signals that are false. Trading systems fail mostly becausetraders fail to follow the rules, but they can also suffer from periodic draw-downs when the signal accuracy misfires. So even a good trader can sufferfrom periodic failure of even the best indicators and systems. The ability tomanage drawdowns largely separates the successful trader from the rest ofthe pack. When you plan your trades, therefore, be sure to tenaciously tradeyour plan if you want to survive.

CONTRARY OPINION VERSUS CONTRARY INVESTING

Many books have been written about contrary opinion in regards to invest-ing. Actually, many of the original works in the area of investor sentimentare from a long-term investing perspective, and largely examine the issuethrough contrarian analysis of stock market fundamentals, such as P/E(price-to-earnings) ratios. This book ignores fundamentals and insteadfocuses only on what I call sentiment technicals: put/call ratios, optionvolatility, short sales, advisory opinion, investor surveys, and quantitativenews flow (my own contribution to the field, which is covered in Chapter19). By using these sentiment measures, it is possible to identify investorsentiment extremes and associated market turning points.

A unique dimension to this book is the combination of price triggerswith sentiment gauges. Sentiment is rarely enough information for a tradingsystem but does provide an excellent initial screen for trading. On theirown, sentiment indicators too often tend to give premature signals. As Idemonstrate in this book, however, performance improves dramaticallyby applying simple price-based triggers for timely entering of a trade attimes of extreme investor sentiment. This secondary set of conditions for atrade significantly increases the hit rate of the trading systems I present inthis book. The use of technical price triggers is thus an important contri-bution for sentiment technicians to consider, a term I use to refer to tech-nical analysts who place great weight on measures of crowd psychology orinvestor sentiment in their trading approaches.

xvi INTRODUCTION

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IS CONTRARY TRADING FOR YOU?

The biggest obstacle associated with using sentiment data and the systemspresented in this book is the difficulty of taking trades when the majority,including most professionals, is betting the other way. With a consensus ofopinion bullish, for example, you have a system telling you everybody elseis wrong, and that you should get into a bearish position. This is clearly notfor the faint of heart. You are going completely against the prevailing think-ing, often against the so-called experts, which is akin to charging headlonginto the running bulls in Pamplona, Spain.

This approach, therefore, requires a solid belief in your trading plan,and the ability to stand alone against the crowd. While this approach mightnot be for everybody, it does offer potential profits for those with the forti-tude and determination to take positions in anticipation of a trend change.This occurs when the investor crowd shifts its opinion, and the marketreversal now becomes your tailwind as buyers turn into sellers en masse atmarket tops, or sellers almost miraculously disappear or turn into buyersat market bottoms.

The frequency and reliability of this pattern—and how to capitalize onit—is the subject of this book.

Introduction xvii

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1

CHAPTER 1

Reflections ofa Contrarianon InvestorPsychology

Being a market contrarian might seem contrary to common sense.Why fight against the prevailing mood of the market and its asso-ciated momentum? Recall the old trader adage “the trend is yourfriend,” which certainly has merit. But what happens if the trend is aboutto come to an end? Then the trend becomes a trap, unless you are care-fully tracking market sentiment, which can help you spot an upcomingtrend change.

Market sentiment is the most important force in market moves, notfundamentals, and the logic is not too difficult to grasp. The age-old truismthat “a thing is worth only what someone else will pay for it” today can befound operating in the “greater fool” theory of price behavior: Stock priceskeep rising only because somebody else remains willing to buy at a higherprice. As a contrarian and sentiment technician, watching the crowd be-come “greater fools” is my business. For example, I attempt to profit fromoverly bullish crowd moods as the prevailing bullish trend suddenly shifts,and the stock market crumbles like “castles in the air,” to quote the famouseconomist John Maynard Keynes. Keynes was describing the more impor-tant emotional or psychological factors—as opposed to intrinsic or funda-mental values—that drive markets ever higher during times of investoroptimism. During pessimistic bouts the same dynamic is at work.

I have found that by properly tracking and assessing investor psychol-ogy, it is possible for the astute trader or investor to make above-averageprofits and, in some instances, exceptional profits.

Sentiment technicians try to take the temperature of both the averageinvestor and the trading crowd in hopes of finding an advantageous entry

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point just before an old trend ends and a new one begins. Therefore, bytrading against the crowd at times of extremely bullish or bearish marketsentiment, contrarians aim to get in early on the start of a new trend, whichfollows a market reversal. Should their prediction be realized, contrariansare positioned to gain from the development and continuation of this newtrend until it becomes ripe for reversal, following another manic swing ofinvestor sentiment to the opposite side of the bull–bear spectrum.

Contrarian sentiment technicians, therefore, do not have a problemwith trends per se. Instead, they simply attempt to spot the zone wherethe prevailing trend is likely to end. Spotting these zones of excessive bull-ish (overbought) or bearish (oversold) investor sentiment is a crucial pre-condition in my trading systems presented in this book. This tradingapproach can produce spectacular profits, as I demonstrate through rigor-ous back testing on numerous stock and futures markets. This testingincorporates my custom sentiment indicators, which are explained in sub-sequent chapters.

The kind of inefficiency shown to exist through investor sentimentanalysis and trading systems tests in this book should rankle diehardbelievers in efficient markets. Systematic, wrongheaded investor or tradersentiment is difficult to refute as a powerful trading technique. This occursbecause it captures periods when the market has become dominated byemotions, as opposed to the textbook mechanism of perfect price adjust-ments for all known information.

THE THEORY OF CONTRARY OPINION

The theory of contrary opinion has a revered status among traders andinvestors. As already mentioned, the approach involves measuring crowdpsychology and trading against the crowd at sentiment extremes. This offersone essential advantage over other technical approaches. Unlike most tech-nical analysis, sentiment technicians incorporate non-price data streams(such as put/call volume ratios alluded to earlier) into their models to aid inmarket timing.

Predicting market tops—and bottoms—is never easy, but enough suc-cessful sentiment technicians and traders exist to prove that the theory ofcontrary opinion has long-lasting merit. The most notable fact is that thesemarket inefficiencies and profitable trading patterns, evident from an analy-sis of market psychology, while well known to smart traders and investors,

2 TRADING AGAINST THE CROWD

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are not easily arbitraged away, as adherents to efficient markets theorywould have us believe. These inefficiencies and patterns may persist and cannever disappear for very long due to the nature of the crowd.

The basic theory is simple: If, during bullish markets, nearly all marketparticipants hold and act upon bullish opinions, then prices are likely todecline. The premise is that everybody who can be in the market already is,and if the view underpinning the crowd’s behavior turns out to be wrong,then everybody is wrong—just when things seem so right. This can producea quick reversal of the trend, as buyers suddenly turn into sellers. The samedynamic applies during periods of panic selling. Markets reverse when sell-ers have been exhausted, often in combination with a sudden revision ofthe economic story and an end to the prevailing pessimism. The selling issaid to have gotten “overdone” and the market turns higher, often fueled byshort sellers who scramble to “cover” (buy back) their short positions.Some attribute this identifiable pattern in the history of stock and futuresprices to the amateurish behavior of the crowd.

However, today with markets dominated by mutual fund managers,who are considered the professionals, it is difficult to make the case thatthe theory of contrary opinion depends solely on the nonprofessional.When market participants act as a group either excessively bearish or bull-ish, their level of experience and capital is irrelevant. Therefore, while manytechnicians (including this one) emphasize the crowd as the less sophisti-cated trader or investor against whom the “smart” money trades, I believethat today the crowd may at times be defined in broader terms; we caninclude some of the professional traders and investors who are tempted togo with the momentum for a number of compelling reasons. Recall thebehavior of fund managers and stock market analysts during the bull mar-ket bubble of the late 1990s; these so-called professionals repeatedly fore-cast the market incorrectly while investing other people’s money on theirpredictions.

FINDING INEFFICIENT MARKETS

Looking back at market booms and busts of the past century, one discernsa behavioral pattern that can be measured in psychological terms. While the late 1990s stock market bubble is the most recent example, it by nomeans represents the only case where long-term deviations from an im-puted fundamental or intrinsic value occurred. This need not be considered

Reflections of a Contrarian on Investor Psychology 3

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