The Joy of Contrarian Investing

Investors are buying puts as fast as they can place the orders. The market's shaking, stock prices are falling faster than a brick dropped from the top of the Empire State Building. Fear. Panic. Get me out at any price.

That describes, charitably and for a family audience, investors' sentiment when the market performs as it did for most of 2000. But investors' feeling disaster is at hand can be the perfect opportunity for contrarian traders, those who believe market extremes represent opportunity, to put their philosophy to work.

In this week's Options Forum, we'll discuss the oft-mentioned contrarian theory of investing and ways to profit from it.

Options guru Larry McMillan, in a chapter he penned for the classic options investing and trading text, Options: Essential Concepts and Trading Strategies, points out that what a contrarian trader or investor is looking to do is the opposite of what the majority of the investing public is doing.

"It is often said that 'the public is right all during a move, but wrong at the extremes," writes McMillan. "According to this theory, the public buys during a bull market while it is rising, but then goes in head over heels right at the top. The same sort of thing is believed to happen in options trading.

The same could be said for a bear market, during which the public sells steadily, but then at some point dumps stock in a frenzy, which would mark a bottom.

The point is, at times of extremes in sentiment, the investing public is trading on emotion and, to put it bluntly, is thinking neither logically nor clearly, so contrarian theory goes. Another factor is that by the time public sentiment becomes so extreme, the cycle that prompted it must be nearing an end.

Contrarians don't always go against the vast consensus of the investing public because the overall feeling in the market is correct. Rather, they try to find the extremes.

So if too many people are bullish, the contrarian wants to be bearish; if everyone's bearish, the contrarian wants to be a snorting bull. According to McMillan, the indicators in the options market that investors can apply to contrarian investing ideas are put/call ratios and implied volatility, as measured generally by the Chicago Board Options Exchange, or CBOE, Volatility Index.

The trick is to find the point at which to make a move, and often contrarians look first to options indicators.

Put/Call Ratio

First we'll take a look at put/call ratios. There are put/call ratios for both equity options and index options. For equity-only put/call ratios, the most widely followed equity put/call ratio is that of the CBOE. It's seen as a more accurate gauge of sentiment because index options are overwhelmingly used to hedge broad portfolios, so the action in those puts is typically busier than that in options on individual stocks.

Call options give the holder the right but not the obligation to buy a security for a specified price by a certain time and are purchased by investors who are bullish on a stock or index. Put options give the purchaser the right but not the obligation to sell a security for a specified price by a certain time, and are used either to speculate on the downside for a stock or index, or to protect a long position.

Contrarian theory says high put/call ratios are bullish, while low ones are bearish. The higher the ratio, the more investors are flooding into the market to buy puts because they're afraid. On the other hand, an extremely low put/call ratio suggests that investors are too complacent and happy with the market and are mainly buying calls.

In the book New Thinking in Technical Analysis, Bernie Schaeffer, the veteran options strategist, says the CBOE equity put/call ratio has been a reliable measure for market timing.

"High put/call ratios are often indicative of excessive pessimism and thus of large amounts of money on the 'sidelines,' " he writes. "Conversely, low put/call ratios indicate a point at which there is so much optimism that there is very little money left to push the market higher."

There are no ironclad levels of extremes in the put/call ratio where it might give off a buy or a sell signal. Still, some options market analysts, including Schaeffer, use a chart of the 21-day equity put/call ratio to help them identify points where the market may turn.

As Schaeffer's Investment Research explains on its Web site: "As contrarians, we believe that when too many speculators are bullish (i.e., the put/call ratio is relatively low), the market is ready to either fall or consolidate. On the other hand, a high put/call ratio is indicative of speculator pessimism, a contrarian signal of a significant market low."

Schaeffer writes that during a bad time in the market, traders should take action only after the moving average peaks and starts to decline. These peaks and valleys can be seen in charts of the moving average.

In late 1999, when the market was soaring, the 21-day moving average was very low, around 0.36, and stayed in that area before turning up in early 2000. Around that time, the market started to go south and the put/call ratio continued to rise, before the market rallied again.

In October, the 21-day equity put/call moving average peaked at nearly 0.65 as the market plummeted sharply. It turned over, and steadily fell to around 0.57 as it enjoyed what turned out to be a brief rally. The moving average then rose again and soared above 0.65 in late December, when stocks were reaching their recent lows.

Last year there were times during the horrific selloffs when the daily reading of the CBOE equity put/call ratio soared above 1, a rare occurrence. This means that for every 100 calls that are traded, more than 100 puts are traded, signaling a heck of a lot of fear.

Volatility Index

Implied volatility is the other big contrarian options indicator used by traders. And while the concept of implied volatility, the market's measure of how much a stock or index may move in the short term, can be complicated, it can be quickly gauged by CBOE Volatility Index.

The VIX, however, isn't as popular as it once was, because the index is based on price fluctuations on S&P 100 index options.

Because tech stocks have taken a larger share of the market, volume on the S&P 100, or OEX, has fallen sharply over the past few years. It is still watched by traders. OEX option volume has declined as other options products, like options on the Nasdaq 100 unit trust (QQQ Quote), have gained markedly in popularity.

This week investors received a new CBOE fear gauge they can watch: the CBOE Nasdaq Market Volatility Index, or VXN. Also this week, the American Stock Exchange launched a volatility index based on options on the QQQ.

Traders interpret the VIX using contrarian theory, meaning that low readings on the VIX are bearish, while high readings are bullish.

So most of the time the VIX is shooting higher when the market is selling off and investors are willing to pay more for OEX put options. That's when contrarians are trying to plot a peak.

The VIX has in the past helped signal major bottoms in the market because of extreme readings in the index. The most extreme reading occurred in October 1987, when the VIX surged as high as 172.79. Yes, 172.79.

That level makes the high readings in October 1997 (55.48) and October 1998 (60.63) look like nothing. Still, those sharp spikes helped indicate that the market was ready to turn around and rally after a steep decline.

Although contrarian trading isn't for everyone, simply being aware of contrarian theory can be a useful weapon in an investor's arsenal.