Tracking Speculative Sentiment in the Market

I recently posted on the importance of identifying who is in the market as a way of gauging how the market is likely to move, tracking the behavior of large institutional participants.  A different way of assessing market participation is by looking at speculative sentiment in the market.  This can be accomplished by looking at total options volume, not just the ratio of put volume to call volume.  

When total equity options volume (volume of options trading for stocks listed across all options exchanges) is in its lowest quartile going back to 2014, the next 10 days in SPY have averaged a loss of -.51%.  When total options volume has been in its highest quartile, the next 10 days have averaged a gain of +.91%.  If we strip out the role of total trading volume from total options volume in a regression model, we find that when pure options volume is in its lowest quartile (as was the case after Monday's close), the next 10 days in SPY have averaged a loss of -.41% versus an average gain of +.49% for the remainder of the sample.  

In other words, when speculative sentiment has died out, the market has been most vulnerable to correction.  Bear moves tend to end in a frenzy of activity, as value and momentum participants become involved at multiple time frames.  Bull moves tend to end in complacency and lack of interest, as the market becomes too dull for momentum participants and too rich for value players.  It is the interplay of high and low participation, tracking the activity of different participants, that creates the dynamics of market cycles.

Further Reading:  Volatility and the Dynamics of Market Cycles
.