Quoting some numbers, the VIX index moved to over 26 in mid-October from a minimum of 10 reached this summer. Volatility is a sign of market nervousness; besides being common during downturns e. Correlation between the benchmark and the volatility is negative, with a value of Figures are even more negative for periods that are more recent: So, is this the beginning of the end of the long bullish cycle for major equity markets?
It is a sentiment measure, computed as the ratio between put options volume and call options volume in a given time frame daily, weekly, etc. On the one side, a high volume of put buyers indicates that there has been an overreaction and the market is often close to a minimum; on the other side, crowds of call buyers typically suggest a possible maximum.
For the purposes of our analysis, the last mentioned seems to be the best: However, as shown in the Chart 2, the ratio is really volatile; therefore, it seems better to consider also a moving average of the indicator either simple or exponential in order to smooth the noise.
By using a simple moving average, we already managed to reduce a lot of short-term noise. The results seem to be satisfactory, with a clear negative relation between the index and our indicator. The graphical evidence is also sustained by statistics, with a negative correlation Nevertheless, there is a relevant issue to solve: As a matter of fact, there are not absolute values, but levels change over time.
There are two possible solutions to this: Static bounds may be drawn taking recent extremes as thresholds: More consistently with a mathematical approach, however, it would be better to use standard deviations from the mean or the median, as showed in the following chart.
The ratio is currently crossing the static mean at 0. A more complex method would be to consider current market volatility or the ratio volatility in order to set time-changing limits to the floating range.
We applied the latter option. A practical example may be to use the same approach of Bollinger Bands, which are computed as standard deviations from the period moving average. In the following chart, we used an exponential moving average.
Then, we computed the upper and lower bands as 0. That said, and taking into account the results from the static analysis, it seems that it would be better to wait for the ratio to reach the lowest band of the chart. Furthermore, considering that our initial aim was to provide some gut feeling of the closeness of bullish market end, it is even more probable that there will be an extreme movement. Therefore, we believe that it is still too early to call for a bear market in the US.
However, volatility has increased and it is likely to grow even more: Thus, short-term market corrections may occur without changing the medium-term view provided by this sentiment indicator. In conclusion, it is also relevant to stress that one single indicator may lead to imprecise signals: And if you find the article interesting, remember to share it.
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