V.10:4 (178-183): On Composite Sentiment by James P. Martin

V.10:4 (178-183): On Composite Sentiment by James P. Martin
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On Composite Sentiment by James P. Martin

Despite all the powerful technical tools available, even the savviest technicians are susceptible to emotion and on occasion succumb to psychological influences that prevent them from taking appropriate action, thus losing out on opportunity. Nevertheless, James Martin writes, how the market reacts is a fascinating subject. He continues his quest for more quantifiable measures for sentiment indicators.

In my first article in the June 1990 STOCKS & COMMODITIES, I showed a refinement of traditional call/put ratios that greatly enhanced their reliability. (See "Using option ratios," elsewhere.) My second in February 1991 delved further into the qualitative interpretation of the ratios and how they should be combined with sentiment surveys and the media. Numerous readers called me, hoping to find some magic mechanical signal that would tell them just when the market was about to turn. I explained that in my sentiment studies I have experimented with simple moving averages, exponential moving averages, envelopes, Bollinger Bands, rates of change and other methods I would be embarrassed to admit that I tried in public. While my studies have produced some general guidelines, I have yet to discover anything purely mechanical when trading off sentiment indicators.

The heart of the problem lies in determining when traders have truly put their money where their mouths are. Is an opinion survey reading at, say, one standard deviation coupled with a call/put ratio at plus two standard deviations a significant contrary opinion signal? Or is it merely a sign that a handful of savvy professionals have made sizable bets in the options market, thereby skewing the options ratios? Conversely, if sentiment surveys move sharply but option activity remains subdued, is it a sign that traders are already committed and are now merely "talking their own book"? Or will options traders be drawn in further before the market turns? This dilemma has led many traders to dismiss sentiment indicators as being too subjective to be considered valuable timing tools.

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