What the "Fear Gauges" Say About the Markets

Sentiment Indicators
Wednesday, July 2nd, 2008

"Be brave when others are afraid, and afraid when others are brave."- Warren Buffett

I'll admit watching the markets turn blood red is troubling. After all, like most investors I'd rather have the color green any day of the week.

Unfortunately, green is a color that hasn't been on the menu much with the bears firmly in charge of the markets. In fact, since the May 19th intraday high on the Dow of 13170, the bellwether average is down 15.53% in only six weeks.

For the average investor that means that fear has suddenly become an unwelcome bedfellow in the long dark night.

To the contrarian investor, however, that same fear often becomes a market opportunity rather than a reason to stare at the ceiling all night. That's because when the herd is stirred too strongly in one direction it often gives experienced traders the green light to begin to nibble.

Of course, it is in these times of extremes that contrarians begin to closely watch the sentiment indicators known as the VIX indicator and the put to call ratio. Between them, they provide a look at how extreme those sentiments—either bullish or bearish—have become.

Then they simply bet against "the crowd".

The idea here is that if the wide majority believes that one bet is such a sure thing, they pile on. But by the time that happens, the market is usually ready to turn the other way.

Of course, as usual "the crowd" hardly ever gets its right. (So much for the rational market theory). So the smart money simply uses these two indicators as a sign to bet against them all.

It's counter-intuitive for sure, but it works nearly all of the time—especially in volatile markets.

Market Sentiment and The VIX Indicator

The more popular of these two sentiment indicators is the VIX indicator.

Using short-term near-the-money call and put options, the VIX measures the implied volatility of S&P 500 index options over the next 30 day period.

But because it is basically a derivative of a derivative, it acts more like a market thermometer more than anything else.

And like a thermometer, there are specific numbers within the VIX that tell the market's story.

A level below 20 is generally considered to be bearish, indicating that investors have become overly complacent. Meanwhile, with a reading of greater than 30, a high level of investor fear is implied, which is bullish from a contrarian point of view.

The smart thing to do then is to wait for peaks in the VIX above 30 and let the VIX start to decline, before placing your buy. As the volatility declines, stocks in general will rise and you can make big profits. You see it time and time again

In fact, the old saying with the VIX is, "When the VIX is high, it's time to buy." That's because when volatility is high and rising, that means the crowd is scared. And when the crowd is scared, they sell, and stock prices fall dramatically, leaving bargains for money making traders.

The Put to Call Ratio
The put to call ratio (PCR), meanwhile is quite similar since it is also a measure of options activity. This correlation is why traders read the put call ratio along with the VIX to provide greater insight into market sentiments. Together, these two gauges are known on the Street as the "fear gauges".

The put to call ratio simply measures how many put options are bought versus call options.

Put options are bought by bearish speculators who expect falling stock prices, while calls are purchased by those who believe that prices will rise. Between them they provide a real time measure of the daily wars between the bull and the bears.

The formula for the PCR then is simple: it is the raw number of puts is divided by the corresponding number of calls. For instance, if there are 50,000 puts sold versus 100,000 calls the ratio is a tame 0.5. That to traders is neutral.

What they are looking for in this case are the more extreme numbers that belie the excessive market sentiments that can be used to bet against the herd.

The most authoritative number naturally comes right from the source, Chicago Board Of Exchange(CBOE) The exchange's equities put call ratio is what most options traders are referring to when talking about put to call ratios.

A low reading of 0.4 is bearish, while a high reading of 0.8 or better is typically bullish.

This is based upon the notion that option buyers are not the most successful traders, because those buyers typically lose about 80% of the time. That gives contrarian investors a bit of an edge since the options crowd is usually wrong.

The equity put to call measure, however, can be extremely volatile. As a result, traders typically smooth out this number out by using a 10 or 21 day moving average as a guide.

"Fear Gauges" the Market Crystal Ball

So that naturally the begs this critical question: What exactly are those "fear gauges" telling us now?

Well, with the VIX currently at 23.88 and the equity PCR at .77 neither index is giving off a strong sign that the markets are about to reverse course in the short term.

Conversely, during the March meltdown the VIX peaked at 35.60, while the equity PCR went as high as 1.35. That is a far cry from where we are now even though the overall declines this go round have been bigger.

That means that the broader market sell off could continue until these gauges tick much higher.

That's what contrarian traders will be looking for in the future as they try to forecast what could be a tradable market bottom.

Unfortunately, however, the herd isn't quite there yet.

Your bargain-hunting analyst,