Intraday Option Patterns - Market Psychology
Trading psychology is a crucial aspect of successful trading, and it involves two key components: the psychology of the individual trader and the psychology of the markets themselves. When we talk about market psychology, we are essentially looking at group psychology — the collective emotional behavior of all traders participating in the market. Understanding these patterns can provide valuable insights into market movements, especially when trading intraday options.
Sentiment Reflects General Moood of Traders
One of the most common ways to measure market psychology is through “sentiment.” Sentiment reflects the general mood of traders, whether they are feeling bullish (optimistic) or bearish (pessimistic) about the market. Sentiment can be assessed through surveys, like those conducted by Investors Intelligence, which poll traders to gauge the prevailing mood. More directly, sentiment is measured through indicators like the put/call ratio, which compares the number of bearish put options to bullish call options traded.
Both survey data and put/call ratios are often viewed as contrarian indicators. This means that when sentiment reaches extreme levels of bullishness or bearishness, it’s assumed that the market is likely to reverse because there are few traders left to push the trend further. For example, if sentiment is extremely bullish, it might indicate that most traders have already bought in, suggesting the market could soon turn downward.
Does Contrarian Thinking Apply to Intraday Trading?
Contrarian thinking works well when analyzing broader market trends, but does it also apply to intraday trading? Unlike broader surveys, it’s impossible to poll traders on a minute-by-minute basis throughout the trading day. However, we can still measure short-term option trading to get a sense of intraday sentiment. My approach to analyzing this involves an intraday option ratio that differs from traditional put/call ratios.
The Intraday Option Ratio Explained
The intraday option ratio I use focuses on the difference between call volume and put volume, relative to total option volume traded. The ratio can range from +1.00 (all volume is calls) to -1.00 (all volume is puts), with zero indicating an equal mix of both. This ratio allows us to see real-time shifts in sentiment and helps us gauge market psychology during intraday trading.
Importantly, this measure excludes option activity on stock indexes, focusing solely on options traded across individual stocks. This distinction is crucial because index options often represent broader market sentiment, whereas stock options can provide more granular insights into specific trading behaviors.
Case Study: Intraday Option Behavior on June 9, 2005
Let’s look at an example of how the intraday option ratio works. Below is an analysis of option trading data from Wednesday, June 9, 2005. The blue line on the chart represents the option ratio (calls minus puts), and the red line shows the five-minute closing prices of ES futures.
On this day, the market exhibited a sharp decline through most of the trading session, followed by a strong bounce in the afternoon. If option traders acted as contrarians, we would expect to see a peak in bullish sentiment just before the market's afternoon drop. However, what actually happened was the opposite. Just before the decline, the sentiment turned sharply negative, showing increased bearish behavior.
As the market reached its low point, option traders were notably bearish. Yet, right before the market bounced, there was a sudden and sharp increase in bullish sentiment. This pattern suggests that the timing of option traders was not contrarian at all but rather seemed to align perfectly with market turns. Their sentiment shifts were timely and often preceded significant price movements.
Interpreting Intraday Option Patterns
Why might option traders exhibit such timely sentiment shifts? One explanation is that sophisticated market participants — such as institutional traders or informed investors — might possess knowledge or insights that suggest imminent market moves. If they anticipate a short-term change, they are likely to use options due to their high leverage and defined risk parameters.
For example, if a trader knew that a company like General Motors was about to face a credit downgrade, they might prefer to buy puts rather than short the stock directly. This behavior would offer a leveraged way to profit from the anticipated drop, with the added benefit of limited downside risk. This strategic use of options differs significantly from the behavior of less sophisticated traders, who might use options casually without considering factors like time decay or valuation metrics.
Thus, the actions of knowledgeable traders can embed valuable information into the very short-term option trading data, which might not align with the longer-term contrarian patterns often seen in broad market sentiment. In essence, the trading decisions of informed participants can create actionable signals even in the intraday option patterns.
Conclusion: Recognizing the Value of Intraday Sentiment
Intraday option patterns offer a unique window into market psychology, highlighting the sentiment of traders on a moment-to-moment basis. Unlike traditional sentiment measures, which often serve as contrarian indicators, the intraday option ratio reveals how option traders' sentiment can precede significant market movements. This suggests that, especially in the short term, the behavior of option traders can provide meaningful and timely insights into market psychology.
Recognizing these patterns can enhance a trader’s ability to anticipate market moves and make informed decisions. However, it is important to approach these signals with caution, understanding that market sentiment can shift rapidly. By integrating intraday sentiment analysis with other technical and fundamental indicators, traders can develop a more comprehensive approach to navigating the markets.
Market psychology is complex, and understanding the nuances of intraday option patterns can provide a critical edge. As you refine your trading strategy, consider how these insights might inform your decisions, and remember that in trading, knowledge is one of your most powerful tools.
