All of us must firmly believe in the market forces. These market forces are nothing but consensus push by one side of the traders Buyers/ Sellers in creating a bias so instead of healthy fight by either side of the parties (In our case Bullish and Bearish), we end up having excessive pressure from one side. The resultant price action can create windfall, if the investor is on the right side of it, or could crush the investor if she is caught on the wrong foot.
Today we will discuss that, amid this volatile market how such consensus could be detected, and an appropriate action that could be taken so that if one doesn't achieve windfall gains there isn't also an accidental loss.
Such gross consensus of market bias gets created by an extreme sentiment. As market activity gets reported, by having a close look at the current market data, one can actually detect these extreme sentiments and get alert before hand.
All of us participants, as a set, more often than not would gauge our consensus expectations by looking at aggregate positions, especially in the F&O market. Just like, if we have days of price rise with increment in Open Interest and the consensus is set to Bullish.
One such consensus can be drawn out of a sentimental indicator called Open Interest Put Call Ratio (OIPCR). OIPCR calculation is very simple.
OIPCR = Total Open Interest of All the Puts* / Total Open Interest of All the Calls*
* of a particular underlying asset, for market mood we would consider Nifty Options.
Now, before we get into that let us understand the intention that causes the action of buying or selling options.
1. Buy Call when Bullish
2. Buy Put when Bearish
3. Sell (Write) Call when Neutral to Bearish
4. Sell (Write) Put when Neutral to Bullish
Back to OIPCR again, like every other indicator OIPCR also works on a simple premise of intention behind action.
Now, one school of thought says Options are like insurance and the providers of Insurance a.k.a. Option Writers know more about underlying asset (in insurance example our life expectancy).
It is because Option Writer pays a margin for a trade which would always have an unfavorable reward to risk profile, so more writers bring in stronger intention.
The idea we are trying to explore here is that if we have more Call writers than Put writers that means majority of writers (the wise ones) hold the expectation of neutral to bearish underlying. While more put writers indicate otherwise.
OIPCR value - if it is more than 1 then the trend is bullish, less than 1 it is bearish. However, an important utility that we have found out of this indicator is much more than this.
The capacity of OIPCR to detect that deadly consensus that we discussed which brings in bone chilling developments in the market.
To put things in perspective, imagine when OIPCR goes far beyond more than one, the mood turns from Bullish to Extremely Bullish. Similarly, if OIPCR is closer to 0 than 1 the situation indicates extremely bearish mood.
Takeaway here is extreme is never sustainable hence would generally be a major turning point in the underlying (major top/ bottom)
Although, the question of how much is too much is very tricky, it could be answered by looking at empirical evidences.
Also Read: Have you heard of OIPCR? It may well answer question of ‘Kay Lagta Hai?’ for markets
Typically, one shall be watchful as soon as OIPCR reaches its reasonably historic bottom or top like that of preceding 52 weeks.
Also, keep a track of basic trend of this sentimental indicator and if you see in rising market (higher highs and higher lows), lowering OIPCR (lower highs and lower lows), it’s time to correct the strategy and rethink the drawdown protections.
It is not an exact science but over more than a decade this one tool has time and again proven that, keeping this analytic in our bag of market tools always pays-off.
(The author is CEO & Head of Research at Quantsapp Private Limited.)Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.