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Getting a handle on market sentiment

Chris McKhann (chris.mckhann@optionmonster.com)

"Be greedy when others are fearful, fearful when others are greedy." --Warren Buffett

I am mathematically inclined by nature and like to look at the numbers, but I also really like looking at the market from the perspective of sentiment.

There are a number of ambiguous ways of getting a read on sentiment. While calling tops or bottoms is almost impossible, I do look for signs that the market is running out of steam in either direction.

One way to do that is listening to TV commentary. When everyone starts talking about the approaching pullback, you can bet that it isn't coming just yet. And when most are bullish, I look for big bears "throwing in the towel."

Magazine covers help as well, carrying the proverbial "kiss of death" to whatever trend they highlight. Along those lines, when random people--taxi driver, waiter, you name it--start talking stocks and tips, you know that the market is toppy.

Not surprisingly, the most systematic way to gauge sentiment is through the option market. Although the CBOE Volatility Index is often misleadingly called "the fear index," the VIX can still be a useful measure of relative fear or greed in the markets.

Hedge funds loaded with Ph.Ds view option data through the lens of math and complex formulas to determine if contracts are relatively cheap or expensive. But simply comparing the VIX to the actual volatility in the market can provide a quick read on expectations. When the implied volatility is greater than the actual volatility in an underlying stock, for example, then options are "expensive."

This tells us that traders are pricing in more volatility, which may be justified. In individual names it can be a bit tricky, as expensive options can be a sign of fear ( buying puts ) or greed ( buying calls ), especially ahead of earnings reports or other potential catalysts. With indexes it is usually a bit easier because the majority of the players are purchasing puts and selling calls against long-equity holdings.

So when implied volatility is high in the SPX, it almost always reflects fear. And because the VIX is an index of implied volatility, it is the easiest way to see this.

Another useful measure is the CBOE SKEW Index . This compared the cost of an out-of-the-money call to a comparable out-of-the-money put on the SPX. The puts have always been more expensive than the calls since the crash of '87.

The skew can be high or low, regardless of the level of the VIX. When it is low, as it is now, it suggests that the big institutional traders are not paying up for put protection. That might make sense as the market runs to new highs, but from a sentiment perspective it makes me nervous.

(A version of this article appeared in optionMONSTER's Advantage Point newsletter.)

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