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A Couple of Things to Worry About November 3, 2007
-------------------------------------------------------------------------------------------------------------------- This is an abbreviated sample of a comment posted for subscribers --------------------------------------------------------------------------------------------------------------------
One of the complaints I get from time to time is that I call some investors "dumb". We track a compilation of indicators that we call Dumb Money Confidence, and some people take offense to that.
I think it's kind of ridiculous to get offended over someone calling an anonymous group of ever-changing market participants "dumb", but it still makes me go back from time to time and re-evaluate whether certain sets of traders are indeed good contrary indicators.
For the most part, I rarely find that their classification should be changed. People who trade certain instruments tend to become overly emotional at extremes, and as long as they display consistent behavior, it is those types of people who we want to monitor on a regular basis.
One of Those Groups - Small Options Traders
I've written about the positioning of the smallest of options traders twice over the past few months (in late July and again in early October), after these traders had become overly optimistic about further market gains. After both instances, equities got whacked shortly thereafter.
This group trades 10 or less options contracts at a time, with transactions that average somewhere between $200 and $2000 per trade.
Despite the recent volatility, these traders are at it again. For the latest week, small traders spent 47% of their volume buying speculative call options, and only 17% buying protective puts.
I put together a more comprehensive indicator this week, which takes into account their call and put selling activity as well. Basically, we're just going to look at their total bullish volume (call buying plus put selling), and subtract their bearish volume (put buying and call selling).
That gives us a kind of oscillator that swings back and forth as these guys and gals adjust their strategies based on the latest market movements. It is depicted below.
We can see that there is a general upward slope in the blue indicator line. This means that these traders have become more and more accustomed to rising prices, and have increased their bullishness on each successive push higher in stocks. They have also become less and less bearish on market declines.
This is a great example of the "institutionalized" mentality of a prolonged trend - as it progresses, with fewer and fewer meaningful interruptions, traders begin to project the past onto the future with increasing aggression. Traders have learned that dips are temporary and they shouldn't panic when they happen.
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