Skip to main content

Lesson 2: the Primary Sell Indicator

Probably the best short-term indicator I know is the Primary Sell Indicator. The reason it works so well is that it is a gauge of the market sentiment of the "real insiders". These insiders are the really experienced traders and even some of the trades made by sophisticated trading computer programs. They are the ones that often are profitable when new traders and investors lose their shirt. The stock market is like a giant game of poker. Like a poker table, the only money "in play" comes from the players themselves -- there is no big winner without a few people who lose. Of course you can make a nice return if you are with the winners and stop being on the losing team. This is the whole point of analysis.
Yeah I know, duhh . . . you don't read my posts for your health.

Puts and calls are derivatives, so called options. These are really highly leveraged bets on the outcome of the market. In simpler terms, options are not all that different  than betting on the outcome of a sporting event. If you are betting on upward movement you buy calls and to bet against the market you buy puts. However what makes options amazingly complicated to understand is (unlike stocks) they have an expiration date. That expiry date creates decay or in a parlance of the geeks of the street, "Theta Burn". That takes an already tough to predict issue like understanding market direction and adds a huge amount of complexity. Based on a Chicago Mercantile Exchange (CME) study of expiring and exercised options covering a period of three years (1997, 1998 and 1999), an average of 76.5% of all options held to expiration at the CME expired worthless.

You start to get an understanding of the complexity of options calculations when you start working with the underlying math. For example; begin with the most basic calculation in options, the Black–Scholes model. Now if you looked at those formals, understand that that is just the start of the math. Because of this inherent complexity the only people who do well in the options game are the people with the powerful computers and the geeks to feed their programs -- they understand the real odds. It’s a lot like dealing with an insurance company; they know a lot more about you chances of dying than you do. It is this inequitable supply of information that we can use to our advantage. The good folks at the CBOE publish the ratio of puts and calls being bought. Now since the options guys know more about the market than the average schmuck who buys stocks, we can use this ratio to predict the regular stock market. Its like they leave us a tell-tale trail to follow. 

To calculate our Primary Sell Model we first need this CBOE Put/Call Ratio (published on the CBOE web site). The Put/Call Ratio is an indicator that shows put volume relative to call volume. Put options are used to hedge against market weakness or bet on a decline. Call options are used to hedge against market strength or bet on advance. We use this indicator to gauge insider market sentiment. Sentiment is deemed excessively bearish when the Put/Call Ratio is trading at relatively high levels, and excessively bullish when at relatively low levels. We can apply moving averages to the CBOE data to smooth out the bumps. Next we use this CBOE Put/Call data in ratio to the market. In other words, the basic data for the Primary sell Indicator is a broad market index, divided by the ratio of the CBOE Put/Call Ratio. To add clarity we make a oscillator out of it, by seeing if a slow and a fast moving average of these calculations are converging or diverging. There you have it, a nice fast reacting wave that leads the market in sentiment predictions.

Lets see it in action. In my postings it often looks like this:
(as always click any graphic to enlarge it) 
The bold line is zero, as the market heads for zero (or lower) the sentiment is decaying and it is unwise to be in the market or at least this is no time to be aggressive. If the the line is heading up the market is building confidence and with it you should be buying and selecting high risk, higher beta equities. Again that is a generalization, I would use an overall long-term indicator like the bull/bear lines (see school lesson one) to decide the best mix of risk on , high safety oriented investment, cash and even short positions. Then I would use faster indicators like the Primary Sell to decide short term risk on risk off. This indicator is accurate most of the time but not perfect. When it is wrong, it means the experts are wrong and yes they too miss now and then. For further confirmation, I also would view this indicator along side other sentiment indicators I use in my postings like the NASDAQ summation index or the % of stocks above the 50 day moving average and so on.

Like all oscillators, another way to use the Primary Sell is to warn you when the market is overheated. For example this is the June 7th 2014 Primary Sell, notice how it is seldom able to stay at values over 5 and the higher it goes from here the greater the chance of a stall.  When you see a high flying Primary Sell it is time to raise your stops and not put new money to work.

Notice I did not say sell, because the Primary Sell is still showing positive momentum any time it is above zero, you run the danger of being shaken out of a market if you jump out too soon in anticipation.

So lets see how this indicator behaves when we put it up against the last 7 year history including the famous crash of 2008. Below is a a long term version of Primary Sell -- from the summer of 2008 until summer of 2014.  At the Top is the S&P500 in green and below is the Primary sell Indicator. As you can see by avoiding the downward slopes you would have been pre-warned out of the market in the sell-offs as well as quickly back in for the bounces. 

Now lets look at our Bull Bear Lines (that we learned about in lesson one) for the same period and you begin to see how you can build a strategy to be passive or aggressive in the market. During times when the green(faster average) is above red(slower average) you can pick much higher risk investments, and during times when red is above green and green is dropping be in cash or even short the market through inverse ETFs (going short in a bull market is a VERY bad idea). When the market is good I said buy higher risk investments but to be clear, I mean good firms but high growth, things like large biotech firms and and technology ventures or firms with a hot new concept like TripAdvisor was in 2014.  I don't mean stupid ideas like some jr. oil and gas venture or a penny stock. I never buy stocks that are not on mainstream exchanges and have at least a medium market cap.  

Popular posts from this blog

Lesson 1: The Bull and Bear Lines – for Phil

When I was living on an island in Belize I met a very amiable man who always had a warm smile a deep tan and a positive outlook on life his name was Phil. We were talking about investments one day and Phil had found a very good financial planner who took care of most of his modest investments. Like many other people I meet Phil does not want to learn to be a trader like me, he just wants a simple way to be sure his money is safe. Also like many people I meet, the 2008 financial meltdown really called into question if it is a safe bet to be in equities at this time. I explained to Phil that you can be safe in the markets if you set limits on when you are owning equities. So here we will discuss a very simple system for protecting your wealth from the worst pullbacks. If you follow this simple system anyone can out perform many mutual funds and still sleep well at night.

Yes I use this system myself, in fact the chart I am going to show you is always the first chart I look at when eval…

Lesson 9: Playing the Odds

So you want to know how I am trading and profitable after 30 years and many are not? Learning that sometimes thing work in the markets and that sometimes they don't but that's has NOTHING to do with good and bad trading. What counts is executing the high probability action.

Take a moment and contemplate this:
There is a sign in a collection agency it says;
"Winning is a just a matter of luck, ask any loser".

You see this in poker, sometimes you do the odds and realize you are probably up against a better hand and you fold. Sometimes it turns out you were bluffed and that hurts, but in the long run if you played correctly over many games you will overall win.  The poker hand pictured above is 7 2 off suit, general thought to be the worst hand in poker. However if per chance the community cards come up as 7 7 7 2 2 you have one of the most unbeatable hands possible.  Just because you won once playing 7 2 does not make it a good hand to play. In fact play it lon…