Options as a Contrarian Indicator

Gabe Velazquez

An astute trader understands two basic, but very important, tenets of free markets. The first one is that for a buy order to fill there has to be a sell order to match it. This implies that there’s always two perceived ideas of were the price of any instrument is likely to go next. The trader placing a buy order believes that price is likely going higher; while, on the other hand, the seller has the opposing view. One of these traders will be wrong.

Secondly, the amount of unfilled orders left in the market will have a big impact on future price movement. This is the function of Supply and demand in the market. The bottom line is that a trader has to have a good idea who he’s trading against and where price is likely to turn.

Free Trading WorkshopThere’s an old saying in the pits (when they were still around) that goes like this: Buy’em when they’re cry’n, sell’m when they’re yell’n. This is a contrarian view suggesting to buy when everyone is panicked and in a state of distress, because this is when most of the selling is finished. Antithetically, when everyone is euphoric and greedy is when markets top, therefore selling is the best course of action when this is happening.

This notion of going against the crowd is widely known throughout Wall Street, but even so, it is much harder to put this into practice as it goes against the human tendency of feeling more comfortable in a group, rather than standing out in a crowd. It’s a fact that when the majority of market participants are strongly leaning in one direction the markets will typically go in the other.

How great would it be if we could actually see where the consistently losing trader is placing their bets? Meaning, are they betting big on the stock market going higher? Or are they convinced that the market is going to melt down? Well, there actually is a place where this information can be found, and that’s in the options market.

The two major options exchanges in the U.S. publish this data every day. The two exchanges are the Chicago Board of Options Exchange (CBOE) and the International Securities Exchange  (ISE), which is my favorite for retrieving this data. This Exchange publishes what they call the ISEE index. The ISEE Index is computed by dividing opening long call options bought by customers by opening long put options bought by customers. The published number is either above 100 or below 100.  A number below 100 indicates that customers are buying more puts (the right to sell stock), meaning they’re speculating on a major market decline. Since these folks are almost always wrong at market turns it is usually a good bet to trade against them. A number under 50 is extreme as it tells us that they are buying puts over calls (a bullish bet) at a ratio of over three-to-one.  This is noteworthy information for traders. In the two charts below we can see that that last two market lows were marked by these options players betting big on a market collapse.

The contrarian indicator can be used to spot profitable trade opportunities

International Securities Exchange Index Chart

This is only background information that helps identify where most options traders are placing their money. Because these market participants are notorious for being wrong, this information can gives us a strong edge. So next time you want to find out what the retail traders are doing, look to the options market, wait for extreme readings, then identify a low-risk, high probability zone to trade on the other side of them. We teach how to identify those zones in our Professional Futures Trader Course as well as our other trading courses at Online Trading Academy.

Until next time, I hope everyone has a great week.

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.