Crowd Sentiment & Trading against them

Crowd Sentiment & Trading against -

The word “Crowd” here is referring to emotionally driven investors/traders with less sophistication, who became uniform in their view of the market.

Why crowd goes together – humans nature is such that most people need to be emotionally secure in their decisions, which is precisely why they get pulled along with herd, and they chose to ignore the history , even their own trade setups/plans and thus capitulate to the herd mentality.

Who else are part of the crowd – today with market dominated by mutual fund managers & chartists who are considered as professional , but how many times these so called experts succeeded. They keep saying “Buy On Dips”, but none of these professionals knows which of their Buy on Dips is saying “Bye Bye”.

There is another argument that charts shows everything so chartists should be excluded to this broader term of Crowd. As Constance Brown says the most of the chartists use their default setting of their charting platform and they never bother to change and they get into same trap of unifom view on the markets. Just check how many times there is consensus with your fellow group on particular stock/market and trades got succeeded? So concluding the argument here is that chartists who use the default settings will be part of this broad term “Crowd”

Hope you now you got the meaning of “Crowd” and their uniform view on the market. So its time we gauge this sentiment, and one of the best indicator to gauge the sentiment is PCR (put call ratio)

Before getting into main topic, just basics on “what is puts/calls”?
Call option – buy in the anticipation of rise in prices
Put option – buy in the anticipation of fall in prices

1971 Marty Zweing invented the Put/Call volume ratio as an indicator to determine whether option crowd is on call-buying or put-buying. When too much buying has been identified with the options crowd titled one-way in their sentiment, you can usually bank on near buy market reversal (short/medium/long term based on the view of the sentiment range)

Which PCR is the right?
Since Marty Zweing first introduced the PCR ratio, there were too many attempts made to refine the orignal method.

1. PCR OI – more open interest in puts suggests bearishness, and more interest in calls says bullishness. There were too many methods on how to interpret OI

2. PCR OI (near the money strikes) – the issue is you are eliminating main crowd here where they normally use to buy Out of money calls (or near out of money calls).

3. PCR Volume - comparative to the OI, volume is the near best indicator. where you add all the volumes traded in the Put and divide with volumes traded in the calls. The issue here is equal weightage for all the strike prices. Suppose you take example of NIFTY trading to 8300, volume of PUTS is 100,000, and CALLS is 50,000. PCR is 2 here, which suggests bearishness. In the above scenario someone bought 70000 extreme out of option strike price at 9500. So just for calculation we remove this 9500 strike price then the PCR will now becomes extreme bullish.

4. PCR Dollar weighted – McMillan refine with value. Instead of PCR volume, this approach creates the ratio of value rather than volume. the calculation goes like this – you calculate each strike price value multiplied with volume traded in that strike price individually and then add all call value and put value and take the ratio of it.

Some mentioned this indicator failed to create topping at the Oct 1987, as compared to traditional PCR volume. Anyway its difficult to convince all what method is right, everyone has their own opinion. At the end of we need to see which is better to our market and how it is able to give maximum favourable signals. With my research goes on all these, I found PCR Dollar weighted was mostly giving favourable signals in Indian markets.

Based on my experience i have found when the PCR weighted goes extreme to greater than 1.75 (better >2) is considered bearish sentiment and expect market to be reversed and vice versa when it falls below 0.3 considered bullish sentiment and expect market to fall.

Since start of the year here is the different stats –

There is one exception in the reading of extremes, i have found during the expiry week (same day or prev day) market expected to carry the same momentum.

References:
1. Original Author for some of the content is John F. Summa (extracted from the book “Trading against to the crowd”)
2. PCR Dollar weighted Approach was defined by McMillan in one of the MTA video library

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