This article will Explain how to read the Market sentiment gadget. This gadget is a quantitative tool designed to help investors understand the current market conditions and help them hone their searches for the best trades. It is based on the S&P 500 index. Market Sentiment will be available to all OptionSamurai’s clients on Jan 2015.
The Market Sentiment chart is composed of 2 axis:
Axis X – is the Trend – Right is bullish, left is bearish and middle is neutral.
Axis Y – is the Implied volatility of the S&P 500 index – VIX index.
This creates 4 squares:
- Square I is Market is bullish and IV high. This usually indicates that investors should look to sell options (as they are relatively expensive) and have a positive delta (the trend is up).
- Square II is market bullish and IV is low. This usually indicates that investors should look to buy options (as they are relatively cheap) and have positive delta (trend is up).
- Square III is market bearish and IV is low. This usually indicates that investors should look to buy options (as they are relatively cheap) and have negative delta (the trend is down)
- Square IV is market bearish and IV is high. This usually indicates that investors should look to sell options (as they are relatively expensive) and have negative delta (the trend is down).
Two important notes:
- Investors don’t have to use naked options, they should use different strategies that accommodate their view on the market. We find ourselves use covered calls, spreads, ratios, married positions etc.
- The chart is continuous. So near the middle the market could be described as “neutral” or looking for direction.
On the chart you’ll be able to see 3 points. These points indicate the last three trading days, and arrows will connect them (from past to present). The darker the color of the dot the further in the past it was.
In the picture above, we can see that the market is bullish and that the IV is high but declining. This tells us that the market is bullish and the trend is decreasing volatility. This implies that we should look for bullish strategies that enjoy time decay such as naked put, covered call, spreads etc.
In future posts we will describe how we build the market sentiment and what the edge it provides.