Reading the Market Sentiment

To reach my options trading goals and trade profitably, I need to be good at reading the market sentiment.

So every weekend before the new trading week, I review the current markets, the general geopolitical events, and economic trends determining the sentiment in the world of options trading.

I use this analysis to prepare new trades and evaluate trades still running. In addition, it gives me all I need to show off my deep knowledge of economics when I see my friends or colleagues again after the weekend 🙂.

One of the first things I learned many years ago when I prepared for trading stocks (and now options) is that it is essential to have a good grip on trends and market sentiments. In the past, most of the information you had to get from paywalled newspapers. Or you had to subscribe to (expensive) financial websites.

Today, such websites still exist; however, if you spend some time searching as I did, you can find most, if not all, of the information you need hiding in corners of the Internet.

Bull and bear

Sources Used

For options trading, I researched which sources I could use to get the market data and information about market sentiment I need(ed).

Most of them use the ‘premium ‘model, which means their basic services are free, and for other services, you have to subscribe. As long as you are not subscribing to one of their paid services, you will have to accept also a lot of unsolicited ads and marketing emails blowing up your email account.

My number one source is Tastytrade. In second place comes the YouTube channel of SMB Capital. The good news is that they are both free. See below for more sources I use.

I regularly visit many more sources on the Internet, and I will share such golden nuggets with you in this blog.

Beware, there are a lot of ‘gurus’ and ‘experts’ promising golden mountains or claiming all markets will collapse tomorrow, and you will lose all your savings, that they have the best money-making strategies, and that you can become very rich if you only pay them some money.

So my question has always been: why do they still need to sell such services if they could have already been swimming in the money using their own strategies?

But let’s start looking at the market. The most known way Wall Street describes market sentiment is using the terms ‘bull market’ and ‘bear market’.

Bull versus bear market

What is a bull market?

Consumer confidence greatly impacts the financial markets for stocks, options, bonds, and commodities. Confidence is growing and higher in bull markets.

They occur when investment prices rise over a longer period. The economies are thriving economies, and unemployment is low.

In such markets, investors are buying or holding onto securities, therefore it is a buyer’s market. 

The longest bull market in the US was from 2009 to 2019. Over time, the bulls have always prevailed.

Bull markets are always followed by bear markets and vice versa.

For those unfamiliar, Wall Street likes to define a bull market as a market where investment prices are rising, economies are thriving and unemployment is low..

What is a bear market?

Bear markets occur when stock prices fall 20% or more over a specific time period. They often occur in periods of economic slowdown and higher unemployment. Investors are selling, looking for the safety of cash or fixed-income securities. The bear market, therefore, is a seller’s market.

Bear markets can last from a few weeks to several years. The dot com bubble in 2000, the housing crisis of 2007–2008, and the market we are in today due to COVID and the Ukraine war are examples of bear markets.

For those unfamiliar, Wall Street likes to define a bear market as anything which has fallen more than 20% (on a closing basis) from its former highs.

In general, pullbacks (up to 20%) happen three to four times per year. Corrections (more than 20%) happen once a year.

Market Indicators

Although I also look at geopolitical events, I mainly focus on the US and US indicators since the US still leads the world’s economy and 99% of all stocks and options I trade are American.

The indicators I regularly look at are the following:

  1. Geopolitical events and economic trends
  2. VIX
  3. Oil & Gas
  4. Gold, Silver & Copper
  5. US Yield Curves (2Y/10Y)
  6. Producer Price Index (PPI)
  7. Consumer Price Index (CPI)
  8. Consumer Sentiment Index (CSI)
  9. S&P 500 Put/Call Ratio
  10. DJI, SPY/S&P 500 and Russell 2000 Index, and Major Market Sectors
  11. US Dollar Currency Index
  12. Bitcoin

Together these indicators give me the overall picture and trends and conditions in which I am trading.

For my journal, I have created a market sentiment template that I update weekly to determine what new trades to set up (or do nothing at all). I also added the related ETFs.

Bull market

Bullish

Neutral/bearish

Bearish

Bear market/crash

1. Geopolitical events and economic trends

Positive trends, stable supply chains

Minor market issues, minor supply chain issues

National events, market issues, bad economic data, mini-corrections

Negative indicators, international events, serious market issues, broader market correction (-10%)

The total collapse of the global market, deep recession

2. VIX (VIX and VVIX)

<15

Lowest volatility, all comfortable

15-19

Market in ‘lull’ mode

20-29

Volatility high

30-39

Volatility very high

>40

Volatility and fear levels highest

3. Oil & Gas (XOP)

Oil & gas

Minor market issues, minor supply chain issues

National events, market issues

International supply chain interruptions, high oil & gas prices

International conflicts involving US, Russia or China, and other main producing countries

4. Gold, Silver & Copper (GLD & SLV & Copper)

Gold, silver, and Copper stable

Minor market issues, minor supply chain issues

National events, market issues

International supply chain interruptions, high oil & gas prices

International conflicts involving US, Russia or China, and other main producing countries

5. US Yield Curve (T10Y3M and US10Y vs US02Y)

Considerably steep curve

Steep curve

Average but still positive curve

Flattening, inverting, and approaching zero

Inverted curve and negative

6. Producer Price Index (PPI)

Lowest price level

Price level higher than normal

Price levels rising fast

The price level is very high

Highest price level

7. Consumer Price Index (CPI)

Lowest price level

Price level higher than normal

Price levels rising fast

The price level is very high

Highest price level

8. Consumer Sentiment Index (CSI)

High consumer confidence

Consumer confidence is less high

Consumer confidence going down

Low consumer confidence

No consumer confidence

9. S&P 500 Put/call ratio (PCR)

Well below 0.5 (very bullish)

Close to 0.5 (bullish)

Between 0.5 and 1.0 (neutral)

Between 1.0 and 2.0 (bearish)

Above 2.0 (severely bearish)

10. Dow Jones (DJI)

S&P 500 (SPX)

Russel 2000 (RUT)

Major Market Sectors (XLE, XLF, etc)

Strong bull market
No real changes in an upward trend

Bullish market
Minor changes in an upward trend

Neutral bullish/bearish market

Increased (negative) changes and “thrashing”

Bearish market

Going down, many negative changes

Bear market

A deep recession or the market is collapsing, or already did so

11. US Dollar Currency Index (DXY)

Very weak dollar versus other currencies

Weak dollar

Neither weak/nor strong dollar

Strong dollar

Very strong dollar

12. Bitcoin (BTCUSD)

Bitcoin rising

Bitcoin rising slightly slower

Bitcoin “thrashing” at the same level

Crypto crashes, market corrections

Bitcoin collapses

No restrictions on trading (except for VIX rules)

Closer watch and reduce trades

More caution needed and reduce trades further

Extreme caution and reduce trades even further

Look to close any open positions and no new trades

Based on the above conditions, I can determine whether or not and the number of extra positions to take, how to manage open positions and whether or not to close positions.

I review all data and information together, and based on the outcome, I determine how I will trade the next week.

I have created a watchlist in TradingView as much as possible reflecting the above list.

Screenshot with on the right the watchlist with market indicators
Screenshot with on the right the watchlist with market indicators

The above set-up is very much inspired by the blog of Sam Gaines (www.optionsdamocles.com) who uses a similar model for his own options trading, Julia Spine’s book The Unlucky Investor’s Guide to Options Trading (using VIX to size options), and SMB Capital’s videos (see this video, also on VIX). So all credits go to them.

SMB Training calls this ‘the big picture.’ It is an important pillar in setting up trades in your playbook.

Events and trends can be breaking news, political machinations, Federal Reserve decisions, or even Twitter trends (Elon Musk!), abruptly changing the dynamics of the current markets and leading to sociopolitical-economical shock waves.

I need to answer what the main drivers for the overall market are. What has and is impacting the world’s economies, especially those of the US, Asia, and Europe? I have to shift through all the news to read the market sentiment in the world.

That could be wars, terrorism, pandemics, inflation, Fed decisions, home sales, and job numbers.

I have a few excellent sources that can help me to gauge the current markets :

  • Options Trades by Damocles weekly blog: I owe a lot to how he set up his blog on options, which inspired me to set up this trading journal.
  • EOption’s newsletter: this is an options broker, but it turns out that if you subscribe to their newsletter (for free!), every day you get a mail with a comprehensive analysis of the market.
  • Seeking Alpha’s newsletters
  • I use sites for news stock selection, charts, etc. like Yahoo Finance, BarChart, TradingView, and Tastytrade.

If you know other or better sites or sources, please leave a comment below, and I will check them out.

2. VIX Index

The CBOE Volatility Index, also known as the VIX, is an emotion gauge for the general investing population. As one-month forward-looking volatility, it is not designed to tell us which direction the market will move but rather how fast it can get there.

The VIX is a 30-day, forward-looking reference to what the traders“believe” the market’s direction and sentiment could be. The VIX programs sift through all the 30-day put options purchases via the CBOE and will calculate an implied volatility value for any given day. If the traders disagree on what they predict the future prices would be, the calculated implied volatility will be very high. But if they are mostly in agreement, the VIX values will be low.

The VIX measures short-term expected volatility in the financial markets via the price of short-term options in the S&P 500. Generally speaking, the VIX tends to rise when uncertainty in the markets is intensifying, as expectations for future movement in the stock market widen.

The VIX set an all-time high of 82.69 in March 2020 as uncertainty about the COVID-19 pandemic stoked intense market fear.

In 2022, the VIX has traded roughly between 16 and 37, oscillating around the metric’s long-term average of 19. Despite increased hostilities in Eastern Europe and rampant inflation, the VIX has failed to break above 40 and is now back to around 20. That indicates that fear in the markets has been relatively contained in 2022—at least thus far.

Volatilty from 2020 to now

VIX levels

A VIX below 15% is very low volatility. A VIX of 15% or below is assumed to be a market at rest. Since the intrinsic nature of the Stock Market is to move up, a VIX close to 15% or lower, it’ll tell us that the broader market is likely to head higher. 

Up to 19% VIX means the market is in ‘lull’ mode. 19% is seen as the ‘steady state’ VIX.

This arena is not adequate for short premium plays which require high volatility. This is where long calls and puts, and debit spreads may be set up. Only when VIX gets closer to 30% selling options become viable.

A VIX at 30% or higher means higher volatility. When selling options you want to be selling out of stocks when the VIX is near 30.

This is where credit spreads, short strangles, straddles, short iron condors, etc. can be played.

Above a VIX of 40%, this is still the case, but given the extreme volatility, you should be very careful.

VVIX

The VVIX Index (VIX Volatility Index) has also traded within a fairly reasonable range during 2022. The VVIX is nicknamed the “VIX of VIX” because it is calculated using the implied volatility of options in the VIX itself. The index measures the “volatility of volatility, or the “vol of vol.”

These days, the VVIX is trading at about 85, which is fairly close to its 52-week low. In 2022, the VVIX has ranged between roughly 83 and 150.

Back in 2020, when the VIX surged to a new all-time high, the VVIX traded above 200. The current reading is 87 which is relatively low for the VVIX

The VVIX is another important data point about sentiment in the current trading environment.

VIX and VVIX 18 August 2022
VIX and VVIX on 18 August 2022

VIX for position sizing

Volatility and the VIX play a very important role in how I size positions and portfolio allocation. Since my focus is on short premium trading I must strike a balance between exposure to large losses and being able to reach sufficient occurrences.

The below scheme I have copied directly from what I consider my options trading bible: The Unlucky Investor’s Guide to Options Trading by Julia Spina.

So I will reduce capital allocation when the VIX goes down and vice versa.

VIX

< 15

15-19

20-29 (last week)

30-40 (few months ago)

>40

Volatility

Lowest volatility, all comfortable

Market in ‘lull’ mode

Volatility high

Volatility very high

Volatility and fear levels highest

Maximum portfolio capital allocation

25%

30%

35%

40%

50%

The Lucky Investor's Guide to Options Trading
The must-have guide for options trading beginners

3. Oil and Gas

The next sectors I look at to understand market sentiment are, due to their huge impact on the global economy, financial markets, and industries, the oil & gas markets.

Sourced data and information are easy to find everywhere on the Internet. I use mainly sites like Yahoo Finance, and international newspapers.

4. Gold, Silver, and Copper (Metals & Mining)

Due again to their impact on the economies, financial markets, and industries, I also track trends in the gold, silver, copper, other precious metals, and mining markets.

Sourced data and information are easy to find everywhere on the Internet. I use mainly sites like Yahoo Finance, and international newspapers.

5. Yield Curves

Understanding yield curves also adds to better reading the market sentiment.

A yield curve is a line that plots the yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.

There are three main shapes of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve), and flat. Upward sloping (also known as normal yield curves) is where longer-term bonds have higher yields than short-term ones. 

Normal curves point to economic expansion, downward sloping (inverted) curves point to economic recession.

Yield curve rates are published on the Treasury’s website each trading day.

Source: Investopedia

I track two yield curves.

i. The 10-Year Treasury Constant Maturity minus 3-Month Treasury Constant Maturity Yield Curve

The yield curve(T10Y3M) compares the 10-year with the 3-month U.S. Treasury bond yield. It gives insight into bank profitability, which is correlated with economic activity. Historically, the yield curve has been a reliable predictor of economic recessions.

Banks borrow money and pay deposits using short-term interest rates (overnight and up to 3 months), then loan money to consumers, homeowners, and businesses at longer-term interest rates (10+ years). Banks make money when long-term interest rates are meaningfully higher than short-term interest rates – a steep yield curve.

When short-term interest rates are higher than long-term interest rates and the yield curve inverts, net interest margins get squeezed, profits fall, and a bank’s incentive to lend money falls. As banks loan less, economic activity tends to follow.

An inverted yield curve has been a good indicator of an economic slowdown ahead. A 10-year-3-month treasury spread approaching 0 signifies a “flattening” yield curve. Furthermore, a negative 10-year-3-month spread has historically been viewed as a precursor or predictor of a recessionary period.

T10Y3M Yield Curve on 18 August 2022
T10Y3M Yield Curve on 18 August 2022

The New York Fed uses the rate in a model to predict recessions 2 to 6 quarters ahead.

Today’s 10 Year-3 Month Treasury Yield Spread is at 0.15. The long-term average is 1.20.

Good sources for the latest numbers, information, and analysis on the 10 years yield curve are Ycharts, currentmarketvaluation.com, and TradingView.

ii. The 2-Year/10-Year Yield Curve

The 2-year/10-year yield curve spread inverted on April 1, 2022, for the first time since 2019.

Screenshot 2-Year/10-Year Yield Curves 18 August 2022
US2Y and US10Y Yield curves on 118 August 2022: highly inverted.

6. Producer Price Index

The Producer Price Index (PPI) program measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services. Source: Bureau of Labor Statistics (BLS).

It is a measure of inflation at the wholesale level that is compiled from thousands of indexes measuring producer prices by industry and product category. The PPI is different from the consumer price index (CPI), which measures changes in the price of goods and services paid by consumers (retail level). Source: Investopedia

PPI for ll commodities on 18 August 2022
PPI for ll commodities on 18 August 2022

7. Consumer Price Index (CPI)

The measure that is most often used to measure inflation in terms of consumers is the consumer price index (CPI). Tens of thousands of items, in several categories, are tracked. The basket of products or services is considered each month, and economists and statisticians look for trends. If the CPI rises, it is an indication that prices could be trending higher, with inflation on the rise.

Screenshot Consumer Price Index (CPI)
CPI on 18 August 2022

8. Consumer Sentiment Index

A low CSI index reflects the general (dis-)satisfaction with the management of U.S. economic policies. A high satisfaction rating suggests approval of the current policy management and implies market stability. Surveys of Consumers (umich.edu).

Consumer Sentiment Index 18 August 2022
Consumer Sentiment Index 18 August 2022

9. Put/Call Ratio

If I add up all the put options contracts bought today and compare it to the total of all the call options contracts bought, I should be able to assume what the current market’s sentiment is right now.

When the ratio between put options bought versus call options bought is above 1, the market is buying insurance to what they may see as declining markets (or a pending market collapse).

Vice versa, when the Put/Call Ratio falls below 1, there is a general sense that the broader markets will increase, and more investors are buying more than selling.

Here are some assumptions when considering the Put/Call Ratios when trading stocks. I can then divide the number of put options contracts bought by the number of call options contracts.

  • A Put/call Ratio of below .5 could mean the market is very bullish. Maybe too bullish. It could be an excellent time to sell stocks high.
  • Between 1.0 and 2.0 the Put/call Ratio indicates a bearish market.
  • A Put/call Ratio above 2.0 could mean it is very bearish. It could be an excellent time to consider buying low.
  • Moving sideways if the Put/call Ratio oscillates between 0.5 and 2.0.

This ratio is fairly easy to understand and is derived from daily trading volumes in the options market. For example, when an equal number of puts and calls are traded in the S&P 500, the Put/call Ratio is equal to 1.

However, when put activity is greater than call activity, the Put/call Ratio rises above 1. And when call activity is greater than put activity, the ratio declines below 1.

It would provide further insight into market sentiment. For example, when investors and traders rush to buy bulls and the Put/call Ratio goes down, that’s an indication that market sentiment has turned bullish. 

Historically, some market participants have used extreme levels in the Put/call Ratio as an indicator for positioning in the market. For example, when the Put/call Ratio jumps toward 2, some investors and traders have interpreted this level of bearish sentiment as a signal that the market has bottomed.

However, previous research conducted by tastytrade revealed that the Put/call Ratio is not a reliable trading indicator. To review that research in greater detail, readers can check out this installment of The Skinny on Options Data Science. Check out this video.

10. DJI, SPX, Russel 2000 Indices, and Main Market Sectors

In general, I look at the main indices DJIA, SPAX, and Russell 2000 (IWM) and the level of volatility or ‘market thrashing’: above 1% in any or all of them might indicate indecision in the market.

“Market thrashing” is caused by ongoing high-volume of trading activity that fails to move the markets’ needle in any direction. When Markets direction is unclear (or highly disputed by the Marketeers), we will see excessive volatility with significant rising then near proportionate falling in markets’ values within a trading period – aka “thrashing.” As the markets’s anxiety begins to wane and volatility falls… and as the VIX continues to fall, the magnitude of the thrashing should taper significantly.

OptionsTradesbyDamocles
DOW (^DJI)

The Dow Jones Industrial Average, Dow Jones, or simply the Dow, is a stock market index of 30 prominent companies listed on stock exchanges in the United States.

S&P 500 (SPX)

The S&P 500 is a stock market index that tracks the 500 largest companies in the U.S. This index represents about 80% of all the capitalization in the country. The S&P is widely considered the best indicator of how all the U.S. markets perform. SPY is the ETF that follows this index

Russell 2000 Index

The Russell 2000 Index measures the performance of 2,000 smaller corporations not calculated in the S&P 500. And being small-caps, they are the most vulnerable to snafus in the U.S. economy. As a result, traders usually shed their risky small-cap portfolios at the first sign of trouble. IWM is the ETF that follows this index

Major Market Sectors

I also follow the major market sectors in Barchart.

11. USD

With the DXY, the symbol for the US dollar index, I track the price of the US dollar against a basket of six foreign currencies. This indicates the value of the USD in global markets.

The basket of currencies essentially consists of nations that have a significant trading relationship with the US and are also hard floating currencies.

The index will rise if the dollar strengthens against these currencies and will fall if the dollar weakens against these currencies.

12. Bitcoin

Finally, I also track Bitcoin and other cryptocurrencies and the general emotional opinions and attitudes of investors toward the asset.

At this stage, I mainly use it for stocks of blockchain companies I trade like RIOT which are highly correlated to Bitcoin.

Other Indicators for Reading Market Sentiment

TLT

But I also want us to pay attention to the iShares 20 Plus Year Treasury Bond ETF (Nasdaq: TLT) — the long bond. It’s important to keep tabs on the TLT because the broader market gets its clues from the bond market.

What I’m trying to say is that the bond market is one of the main reasons why communications and chip stocks have stopped trading lower.

‘The Misery Index

I also like the ‘Misery Index’ created by Sam Gaines who maintains the OptionsTradesbyDamocles blog.

He adds the annual inflation and unemployment rates and calculates the US’ economic health. The outcome he calls the ‘misery index.’

Here is an example.

Misery Index

  • Inflation Rate: rose 0.8% in Feb ’22. Now up to 7.9% from a year ago.
  • Unemployment Rate: February rate = 3.8%. Slight drop from 4.0% in January

Misery Index = 11.7% (7.9% + 3.8%). Slightly up from 11.5% last month. (Unchanged from last week)

Conclusion

The input I collect on all aspects of market sentiment plays an important role in portfolio allocation, what stocks and how many contracts I select for trading the next week, and decisions I need to make on open positions, whether or not to close them or let them run.

The main indicators I use on a day-to-day basis when looking at my trades are the ‘big picture, the VIX, the main sector ETFs and the indices or their ETF equivalents.