Feb

26

Gut Feelings, from Bill Rafter

February 26, 2016 |

Gut feelings matter, but not the way you think. An individual’s gut feeling is anecdotal. Chances are that even he cannot statistically study his sympathies. However many of us model the gut feelings of investors at large, and those can be statistically studied. Here are a few examples:
 
Commitments of Traders of futures. Many researchers ply a theory and then try to find data to support it. And their theory typically revolves around following the large (reporting) traders and mimicking them. The trouble is that not even the big guys are right all the time. A better approach is to examine the data without a preconceived theory. In doing so you will find that the small (non-reporting) traders are more consistently wrong than the big guys are right. That is, winners rotate, but losers are consistent. Further analysis reveals that the little guys tend to be even more wrong when they are short. And the best combination is when the little guys are short and the big specs are long. Following the hedgers should be avoided as the hedgers speculate, but on the basis, not the actual price. If you don’t know what that means, don’t play in that venue. 
 
Options data. This usually takes the form of the putcall volume ratio. Excessive levels tend to occur at market turning points. And by the way, the smart money bets against the excessive level. One problem to be mindful of is that most researchers look at CBOE data, which typically only constitutes a third of all option data. If you want to get it all, get the Options Clearing Corp data, which is free just as CBOE data and more reliable.
 
While you are looking at option data, go a step further and look at the open interest levels.  I assure you that if you like putcall volume data, you will value the open interest data more.  The latter also tends to give less ephemeral signals. 
 
Is there any way to combine the two?  You betcha!  In any given period the number of New Positions (NP) equals the volume plus the change in open interest.  Further, the total open interest divided by the backward cumulative NPs identifies a number of trading days which can be described as either the age or average holding time of those positions.  On a very broad scale that data gives a view significantly different from putcall volume, and one that is quite reliable. 
 
Polls?  There used to be a newsletter which purported to measure contrary opinion for futures. What the publishers (Mr. James Sibbet and Earl Hadady) did was rank the bullishness of various newsletters and take a percentage. The theory was that if every publication was bullish, the market was overbought. The trouble was (paraphrasing Keynes) opinions could stay bullish for longer than you had margin money for picking the top. However if a market was up in the high 90s percent bullish for several weeks, the first downturn in opinion to even mid-80s presaged a price selloff.  It wasn’t the same people each time, but when the collection of gut feelings changed its momentum, the price tended to go along. 
 
While on the topic of polls, VIX and its offshoots are surveys that are very reliable. 
 
Price alone. What do you do about a market without telltale derivatives or surveys of newsletters? If you run a regression fit of the price data and extend it, you have a forecast. The deviation of the actual price from the forecast provides a measure of the combined opinions of professionals regarding that price. Small deviations go hand in hand with low volatility which is bullish on prices of assets that go into portfolios. Large deviations are scary which manifest themselves in price discounts. 
 
So all in all, Virginia, gut feelings matter. 


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