The Secret about Market Timing I Wish Everyone Knew

Keith Fitz-Gerald Dec 10, 2014
29 

Many investors are trying to time the markets, especially lately with concerns over low oil prices, global woes, and Chinese growth in the headlines.

I totally get where they’re coming from. The idea of picking market tops and bottoms is very seductive.

But they may as well try to catch falling knives…

The most recent DALBAR data shows that the return of investors trying to time the markets is a pathetic 1.9% a year over the past 20 years. Worse, they would have to be right a staggering 82% of the time just to match “buy and hold” returns, according to Nobel Laureate William Sharpe.

Clearly market timing is one tactic that does not build Total Wealth. But here’s the secret.

You’re much better off trying to understand sentiment – because that’s how you identify the best and the worst times to put your money to work and rack up the biggest gains.

Today I want to teach you how to do that…

Sentiment Tells You Where Things Are Going

If you stop and think about it for a moment, tracking sentiment makes a lot of sense.

The financial markets are a construct that embodies the collective wants, desires, and aspirations of millions. As such, they reflect emotion. Therefore, if you understand what kind of “mood” they’re in, you can make the right moves ahead of time and gain the upper hand when it comes to building wealth.

One of the best ways to do that is via a technical tool called the “Put/Call Ratio.”

It’s the only tool I’ve seen in more than 30 years of analyzing markets that works consistently and accurately to predict every single one of the market’s major turning points.

The Put/Call Ratio measures sentiment by calculating the difference between thousands of puts and call options traded in the United States stock markets.

Viewed as a proportion, the ratio can be calculated on any given stock, ETF, index, or other investable instrument for which there are options traded. So you can apply it to individual securities, too.

Generally speaking,Β higher readings reflect excessive bearish behavior because put volume exceeds call volume. Conversely, lower readings suggest excessive bullishness because more calls are being traded.

The problem is that when you look at the data in isolation, it looks like either an EKG from hell or an earthquake tremor map.

To get around that, most traders “smooth” the data over a period of time using a moving average to get what’s called a “normalized” ratio that’s not so spikey as to be useless. Day traders with short attention spans seem to like 10-15 days. Position traders may push out to 200 days or more.

I suggest you start with a 20-day period, because that’s a good approximation of the market cycles an average investor is going to encounter the majority of the time. But, again, you can lengthen or shorten this as you wish depending on your individual preferences.

There’s also something called a Weighted Put/Call Ratio. In contrast to the regular Put/Call Ratio, which captures volume only using the number of contracts traded, the Weighted Put/Call Ratio is a mathematical blend of volume and price. The thinking is that traders will spend more money as they become more emotional near market tops and bottoms.

That certainly jibes with my experience.

Here’s How to Read the Ratio (and the Advantages It Gives You)

For example, take a look at this chart that overlays the S&P 500 Index against the 20-day moving average of the Put/Call Ratio. (You can find this info yourself – absolutely free – from dozens of financial providers or simply click over to www.indexindicators.com.)

At first glance, it’s a squiggly mess. But if you relax and let the lines talk to you, a very clear picture emerges as do a few key takeaways.

  1. First, there have been four times the Put/Call Ratio has hit 2 standard deviations that I’ve circled in green since late 2011. Each time, the markets have moved higher because excessive bearishness is an inverse argument for a bullish reversal.
  2. Second, there have been three times the Put/Call Ratio has hit -2 standard deviations that I’ve circled in red. Each time, the markets have fallen because excessive bullishness is an inverse argument for a bearish reversal. Not immediately mind you, but close enough for government work as the old expression goes.

Here’s the thing. Knowing how to read this chart would have…

… allowed you to capture every single one of the market’s major turning points since 2012; and

… help you know when conditions favored buying or selling.

If you’re like a lot of people, you may be kicking yourself right about now because you’re imagining how much more money you could have made or could be making. That’s perfectly normal (and a valuable part of learning, too).

So what’s the Put/Call Ratio telling us now?

Let’s take a closer look together and see.

What the Put/Call Ratio Says Today

Right away we see that the S&P 500 Index is topping out. To my naked eye it appears to be losing momentum and seems like it wants to roll over like a Slinky that you may have played with as a kid going down the stairs.

A quick look at the Put/Call Ratio and I see that it dropped a full two standard deviations below its normal range at the beginning of December.

We know from past history (and our second chart) that this is a reading consistent with short-term turning points so this tells us we immediately want to be on guard.

At the same time, it also suggests that we want to check our trailing stops. There’s no sense in letting a reversal catch you by surprise, especially since the Put/Call Ratio has told you that this is a possibility for the better part of a month in advance.

Anecdotally, this makes all kinds of sense coming into the holidays. Volumes are getting thinner by the minute as traders the world over get ready to take some time off.

The other thing that stands out when I look at the data is a great opportunity for aggressive traders. I call this “capitalizing on chaos” because you’re using this information to make money at a time when other investors are blindsided.

For example, I recently recommended my paid Strike Force subscribers short a media darling that’s making its share of headlines right now – or consider buying put options as a means of doing just that. So far the short has returned 17% while the put options are up 212.40% as I write this.

I’ll be back Friday to let you in on that… and continue the discussion.

Best regards until next time,

Keith

29 Responses to The Secret about Market Timing I Wish Everyone Knew

  1. LouisH says:

    Hi Keith
    Thanks for all your great advice and tips.
    When I look at the put/call charts you describe they seem to be similar to the VXX chart and maybe other volatility charts too. Is this the case, is there a correlation between the two?

    Best wishes and thanks
    Louis

    • Keith says:

      You are more than welcome Louis.

      That’s a great observation. There is some similarity to the VXX chart but, as you might suspect, a few wrinkles due mainly to the computerization over the past few years and a pronounced shift in something called the “skew” following the Financial Crisis. I’ll cover both in an upcoming column.

      Best regards and thanks for being part of the Family, Keith πŸ™‚

  2. Don Rossi says:

    Thanks for the article.

  3. Kenny says:

    That’s golden! Thanks for the education Keith.

  4. Alan says:

    First you say lower readings reflect more calls being traded, which suggest traders anticipate higher prices ahead. Then you show that lower readings anticipate falling market prices. These two statements are contradictory. Does this mean that a bottom on the Put/Call graph means that call activity is about to decrease, leading to (or anticipating) falling stock prices? If so, it seems it is really the slope of the Put/Call graph that is indicative, not so much the value.

    • Keith says:

      Hi Alan.

      Perhaps I could have made the chart a bit more clear. Sorry about that – but I wanted to use a source you could reference yourself in the interest of education.

      Reading the Put/Call Ratio is a lot like reading bond yields in that the readings are inverse to the expected action. When bond yields are rising, for example, that means bond prices are falling. In this case, a high Put/Call Ratio reading generally arrives when the markets are lower and vice versa.

      And, as you point out, that means slope can also be used to interpret trading action, especially if you’re a day trader or looking for quick market action. For most investors, though, it’s the absolute readings that suffice which is what I’ve tried to highlight here.

      Best regards and thanks for being part of the Family, Keith πŸ™‚

  5. Doug says:

    Hi Keith,
    I just tried to duplicate your chart on the http://www.indexindicators.com website, but the chart I get doesn’t look anything like yours. I used the same parameters, S&P 500 vs 20 MA of Equity Put/Call. I did this at 12:50 EST on Tue. I don’t get it.

    • Keith says:

      Hi Doug.

      Thanks for letting me know. I initially prepared my chart on Friday the 5th. That means the scaling is going to be different because the markets and the underlying data have changed.

      Best regards and thanks for being part of the Family, Keith πŸ™‚

  6. Emmanuel Eyssautier says:

    Keith do you know how to set up this tool on TOS?
    Thanks

    • Keith says:

      Hello Emmanuel.

      Unfortunately, I don’t believe TOS has this capability which is odd given the fact that it’s built around options trading. I know users have been asking for it for years. There are some custom coding solutions but those are approximations.

      Best regards and thanks for being part of the Family, Keith πŸ™‚

  7. Rich says:

    Thanks for passing on the helpful information. Just bought a couple of puts yesterday for the first time. This was a good affirmation that I am reading the current market correctly and taking appropriate action.

    • Keith says:

      Thanks for sharing Rich.

      It certainly sounds like you are on the right track. Just make sure to keep your risk capital limited and not bet the farm on any single move.

      Best regards and thanks for being part of the Family, Keith πŸ™‚

  8. Bob says:

    The term put/call ratio suggests to me that the number of puts is in the numerator, which means that the higher the ratio, the more put options are being traded. This is the opposite of what your article describes. Please clarify.

    • Keith says:

      Hi Bob.

      Thanks for the sharp eyes. There was a typo in the original draft that’s now been corrected.

      William Dahl
      Associate Editor

  9. Doug says:

    Ok, I found the reason. You have to use the 20 Day MA Smoothing as well, which I didn’t do at first. Now my chart looks exactly like yours. This is really useful stuff. Thank you so much for this. Merry Christmas!

  10. mike says:

    Brilliant! Thank you Keith, and Merry Christmas.

  11. Joe Buhler says:

    All the lengthy article is telling me is how to time the market!

    • Keith says:

      Hi Joe.

      Hmmm…if that’s your key takeaway, then I haven’t done my job as well as I could.

      The DALBAR data shows timing the markets is an all in or all out decision as practiced by most investors (and badly I might add). My point is that by understanding sentiment you know when conditions favor buying or selling so you can make minor course corrections that contribute to higher returns over time. This works because the markets have a distinct upward bias – something I will talk about more completely in an upcoming column.

      Best regards and thanks for being part of the Family, Keith πŸ™‚

  12. JERE SHIMA says:

    Can you do this for individual stocks. I tri24ed but couldn’t get it.

    • Keith says:

      Hello Jere.

      Yes, you can do this type of analysis for any optionable security using nothing more than Excel. The key is having the underlying data and that depends on a combination of things ranging from your broker to your trading platform and analytic tools.

      Best regards and thanks for being part of the Family, Keith πŸ™‚

      • Patricia Vasquez says:

        I wish that I could understand all that you teach so eloquently. Maybe one day my light bulb will turn on. I at least get “E” for effort.

  13. Ed says:

    Feliz Navidad Keith t you and all your loved ones keep the goddies coming !
    God bless you and Happy New Year 2015
    from Las Vegas

  14. Robert Holcomb says:

    Wow…great set-up chart. Thanks for the info. First time I’ve heard about this one.

  15. pete soukir says:

    Hi Keith,
    THANKS FOR THIS GREAT ARTICLE. In your chart, you mentioned using the 2 standard deviation, is it something that already added automatically to the chart or you have to add it yourself, if so, how to add it?
    You seem only act /trade only when the ratio touches the plus ou minus 2 standard deviation, why that? And never mind the size of the ratio top or bottom, why not taking trade any time the put/call ratio is bottomed or topped ?
    Finally, after observing a ( any )top or bottom of the ratio, do you use any other indicator for confirmation; if so, could you please tell me which one? Or do you have to wait for or give some time to the ratio to concretize? I meant if you just jump once you see a top or bottom. ..
    Thanks in advance for your answers and I am looking forward to reading u.

  16. Dennis Mazurk says:

    Your model suggests a correction in the beginning of December and there was one for the first two weeks in December. I have been told that this is normal year end tax selling and that the market should resume as it has in the last week, Could the correction your model predicted be over or is it indicating a much larger extended correction?

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