Making Profits Through Understanding Market Psychology

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Includes: MDLZ, SHLD
by: Inglefox Investing

I am a big believer that the markets, especially in the short term, aren't moved by company fundamentals or any of the other logical indicators. These indicators certainly play a role, but they don't move share prices in and of themselves.

There are certain catalysts that can move a share price (such as an FDA decision for a drug company), but there is another force at play that can move share prices significantly one way or the other without one of these catalysts. To understand this force it is important to understand that the market is very much a human driven entity and thus it can be psychologically studied.

In many of the articles that I have previously written I have used certain wording and talked in generalities, purposely leaving some information out and including some correct but overall purposeless information. I did this because I was trying to provoke a response to these certain elements in order to more closely study the overall market psychology. There are times when people did not respond at all to items that I thought to be very provocative and times when people responded negatively to items that I initially thought to be harmless.

My conclusion from this and from my other close studies of the psychology of the financial markets is that people, perhaps without even knowing it, trade and invest as one "herd". I have found signs of this "herd mentality" in every aspect of the financial markets.

I have collected enough information that I feel comfortable making the following generalizations about the "herds" of the financial markets:

  1. No matter how bad things may get, the herd still wants to be long stocks.
  2. The herd is very short tempered with people on the short side.
  3. If, on the rare occasion, a herd does go "short" something, watch out below for that stock.
  4. The herd, as is normal human tendency, will do everything possible to defend their positions even if they are proven wrong time and again.
  5. The herd plays favorites with certain companies.
  6. The herd will ignore it when the "writing is on the wall." (By this I mean that sometimes things are just blatantly obvious and yet the herd will hold on and go down with the ship... just ask Joe Lewis about this.)

I don't think that people trade or invest in herds intentionally, but rather the "herd" is formed when an overwhelming majority of traders and investors make the same decisions based upon the same information. Take for example the bank stocks in 2008 after the write-downs had been priced into the shares (the write-downs would classify as a catalyst). In many cases, the "herd" decision to continue putting selling pressure on the bank stocks was a result of bad fundamentals, so this would seem to contradict my earlier assertion that stocks don't move on fundamentals in the short term.

Though I admit that sometimes a stock can move on short term fundamentals, the existence of the herd mentality is proved when the herd sells off shares of a company that is in the same industry as the one with the poor fundamentals despite the fundamentals of industry competitors being perfectly good still.

Back to my example of the bank stocks, once a few stocks were sold off due to poor fundamentals or big write-downs, even the healthier banks saw their share prices fall sometimes just as much as the banks with the tremendous write downs.

This is simply a result of a logical human decision process that goes something like this: If bank A and bank B have had these tremendous write-downs then bank C probably will at some time in the future. The logic is perfectly sound and I think that it is a very natural human logic. It can be found everywhere in the market, the fact that so many people buy into this very type of logic is what forms the herd mentality. The question now becomes "how do I profit from understanding this market psychology?"

Well, as I said earlier, this "herd mentality" can be found everywhere in the financial markets, not just in the stock market. So, the way that I answer the question of how to profit from the herd mentality is that I look to the herd in the options market. Stock options, and in particular LEAPS, are good indicators of what the market players think is going to happen to a stock in the future. The options market has a herd (albeit a much smaller one) just like the stock market does and if you look for just the right indicators, you can make a generalization about the future of certain stock prices based upon where the money of the options market herd is going.

What I look for is levels of high open interest either on the put or call side. If I find an abnormally high open interest level I first search the headlines to see if there is any glaringly obvious reason for why the open interest would be so high. If I find a reason then I usually move on, but if I don't I then apply a set of strict rules which will help to further weed out the options which are unsuitable for this strategy.

Firstly, the option indicators are basically useless if the option is too thinly traded. In the thinly traded options, one person could hold a large position that is skewing the options for that particular equity and it would certainly not be wise to take up a position based upon one other individual's conviction about a stock. There is no definitive rule that I follow here, but do look for consistent daily volumes of 500-2,500 minimum and open interest levels of at least 5,000.

The next rule is that you have to compare apples to apples. By this I mean that if you find an abnormally high open interest for a call or put you have to compare it to it's equivalent put or call. For example, say a stock is trading at 53 and the 60 calls are showing an outrageously high open interest. I have found that many people, in finding abnormal open interest levels, simply will compare these 60 calls to the 60 puts.

While I do calculate the same strike ratio, I don't think that this is as important as what I call the "straddle strike" ratio. The straddle strike ratio calculates the ratio of the open interest in the 60 calls against the open interest in the 45 puts. I find this to be important because it calculates how many options are outstanding that are making the exact inverse bet on the share price as the 60 calls. 45 puts are the exact inverse of 60 calls in this situation because they are each two strikes away from the actual price in their own direction. I also calculate the opposite ratio which measures the ratio between the calls with the highest open interest and the puts with the highest open interest, regardless of strike.

While these three ratios are all important in deciding if an open interest level would be classified as abnormally high, perhaps the most important indicator is the total call to total put ratio. This is calculated simply by adding up the open interest on all the calls and dividing that by the total open interest for all of the puts. This total ratio ensures that apples are being compared to apples.

Again there is no definitive rule for what ratios to look for. Some people are more comfortable than others making a generalization about a share based upon lower ratios, but I generally look for all ratios to be at least 2-1 with the exception of the total ratio where I look for 1.5-1.

The next rule that is important to follow is that you have to look at recent share performance to determine if whatever is causing the abnormal options open interest has already been priced into the stock's share price. This will have to be purely a judgement call, but sometimes it is blatantly obvious. The positive note is that you can always wait a little while and then re-evaluate because the LEAPS are not going anywhere.

The last and perhaps most important rule is that you have to continually evaluate your position. It is important to remember that the options market is highly liquid and full of speculators who can change positions at any moment. You must continually monitor the options that you are using as your indicator to ensure that you are still on the same side as the herd.

I have employed this strategy of using the options market for some time now and have seen an astonishing 70% success rate thus far and more often than not, the times that I am wrong are times that I have violated my own rules. My most profitable move yet based on this strategy was taking a short position in Bear Stearns based upon the January 2008 LEAPS.

In taking a close look at the January 2009 LEAPS, two stocks in particular that stand out are Kraft (KFT) and Sears Holdings (NASDAQ:SHLD). The ratios for these two companies are as follows:

click to enlarge

These ratios all lean toward the bullish side of these two companies and all of the criteria mentioned above is met. It is still important to remember that though the options market can provide a good indicator of future expectations, it is not correct all of the time. The options market "herd" can indeed be incorrect.

There is a further risk that the situation for either Kraft or Sears Holdings could deteriorate and the options indicators could change. With close observation though, this risk can be mitigated.

In the end, market psychology is one more tool to put in your tool box. In my experience, the options market is a good way to use the market psychology to an advantage. I wouldn't recommend changing your entire portfolio based upon this one strategy, but I thinking adding a few stocks based upon it is not an entirely bad idea.

The bottom line is that, though the herd mentality does not always make the correct decision, it does carry a significant amount of money and influence into the marketplace. I think that you can use the herd to piggyback your way to a little profit, but it does take careful study of each individual stock in order to fully understand the psychology at work.

Disclosure: author holds a long position in SHLD and KFT.