Learn To Use Investor Sentiment To Your Advantage When Trading Options

Investor sentiment is a great tools that you can use to your advantage when trading options. The reason I love using it so much is because it’s relationship to the general contrarain theory when trading which states the follwoing:

A contrarian believes that certain crowd behavioramong investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company’s risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don’t pan out.

What Is “Sentiment”?

Sentiment is a measure of the bearishness or bullishness of market participants. Major market turning points can be accompanied by highly skewed investor sentiment, with extreme bearishness seen at market bottoms and extreme bullishness at market tops. Research has demonstrated that changes in investor sentiment may trigger changes in asset prices, and that investor sentiment may be an important component of the market pricing process.

How Do You Measure Investor Sentiment?

A common and widely accepted means of ascertaining this balance of power is to take a quick reading of a sentiment index, the most prevalent of which is the Investors Intelligence reported figures each week. Below is the most recent reading from the Investors Sentiment and Intelligence. In addition I’ve overlayed the recent index chart for the SPX for comparison. *Click to Enlarge*

Generally speaking the Investor Sentiment theory holds true. When most investors are fearful and bearish, you want to be more bullish. And when most investors are greedy and bullish, you want to be cautious and/or bearish.

An Option Trader’s Tool

With everything we have covered it’s clear that the best use of Investor Sentiment when trading options is it’s ability to “forecast” market tops and bottoms that are near. If you see a high reading of bullish investors you can be safe taking a Put positon and/or a short Call position above the market. All in all, if your ever feeling confused on the market, just take a quick look at the Investor Sentiment and see if you are part of the crowd or leading the new trend!