From the January 01, 2011 issue of Futures Magazine • Subscribe!

Market internals beat the herd

Put/Call ratio

The put/call ratio is based on Chicago Board Options Exchange (CBOE) statistics. The ratio equals the total number of puts divided by the total number of calls traded. When more puts are traded than calls, the ratio will exceed 1.00. As an indicator, the put/call ratio is used to measure market sentiment. When the ratio gets too low, it indicates that call volume is high relative to put volume and the market may be overly bullish (see "Selling down," below). When the ratio gets too high, it indicates that put volume is high relative to call volume and the market may be overly bearish.

Put/call ratio = number of put options / number of call options


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This indicator can be a little tougher to use because when the market is trending down, the ratio tends to fluctuate in the upper end of the scale between 0.75 and 1.20. In an uptrending market, the indicator will trade between 0.35 and 0.75. As long as you monitor the upper and lower range for the current market trend, your analysis should be right on track. In addition, if you zoom out slightly on the chart, you will see the average range it has been trading in, and then you can set the upper and low bands accordingly.

Back in late August, the S&P 500 was trending down, and a good strategy was to sell bounces in the market. When the broad market bounces and we see the put/call ratio drop into the lower band, it says that the majority of traders have gotten bullish. This tends to happen once a previous high is broken, as it triggers short covering and breakout traders start buying.

While there are other times on this chart where the indicator traded into the lower range, there was not a signal to short the market because the other two indicators did not confirm the extreme sentiment level. For this strategy to be the most effective, they all must have an extreme reading for the trade to have the best odds and greatest profit potential.


Nyse buying/selling volume

The NYSE buying/selling volume indicator is a simple volume-based indicator that measures fear and greed in the market. It routinely is a powerful tool for timing market tops and bottoms. Calculated by taking the NYSE buying volume and dividing that by the selling volume, it measures panic buying and acts as a contrarian indicator. It is not an indicator that many other traders follow, but is critical for getting a feel for the rhythm of the market.

NYSE buying strength = Up volume / Down volume

When you see this indicator rise to about 3.00, it means there are three buy orders for every one sell order on the NYSE. The majority of traders (the herd) are buying. Obviously, the higher this indicator moves, or the longer it stays above 3.00, the more potential there is for a sharp sell-off (see "Tracking the herd," below). Obviously this is only a confirming indicator; both the indicator and the market can continue to rise after touching 3.00.

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Putting it all together

With these indicators, you can stay ahead of the herd and capture quick sharp moves while the masses are still wondering what happened. As always, logistics are important. Focus on 15-minute charts. Trade only with the trend. For instance, even though the market bottomed in July the downtrend exploited in "Extreme reactions" was still in place until the trendline was broken in September.

Do not get greedy. This strategy is designed to capture short-term market swings; take profits at defined levels – 1%, 2%, etc. If you wish to hold on for larger gains, it’s critical to take partial profits at a 1% gain and move your protective stop to a level that locks in a profit for the balance of the position.

Wait for all three indicators to reach extreme levels concurrently before you initiate a trade. The market trend can keep individual measures at extremes for one to two weeks. Trading on the anticipation of an overbought/oversold condition before all three indicators confirm your suspicions is a great way to lose money. Be patient, and wait for the indicators to confirm. There will be plenty of time to acquire a quality entry.

The strategy as presented works best in a downward trending market. While it also works well in a bull market, there are some minor changes required on each of the indicators that affect their user-friendliness.


Chris Vermeulen can be reached at 
Chris@TheGoldAndOilGuy.com or from his website www.TheGoldAndOilGuy.com.

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About the Author
Chris Vermeulen

Founder of AlgoTrades Systems., internationally recognized market technical analyst and trader. Chris is also the founder of TheGoldAndOilGuy.com, a financial education and investment newsletter service. He is responsible for market research and trade alerts for of its newsletter publication. He is the author of “Technical Trading Mastery – 7 Steps To Win With Logic” and has  been featured in Futures Magazine, Gold-Eagle, Safe Haven, The Street, Kitco and dozens of other financial websites. 

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