Stephen Briese Commercials Movement Index Indicator Ninja Trader

Contrary Opinion12

The contrarian lies somewhere between the fundamentalist and the technician, basing actions on the behavior of crowds, in this case the market participants. The contrarian sees the end of a bull market occurring when everyone is bullish. Once all long positions have been set, there is diminishing influence by the bulls; moreover, opportunities always lie in the reverse direction from crowd thinking.

Contrary opinion alone is not meant to signal a new entry into a position; it only identifies situations that qualify. It lacks the timing. It is more of a filter than a trading system, a means of avoiding risk and finding an opportunity. Consider the patterns that appear in every prolonged bull or bear move. First, there is a place where the direction is generally accepted as the major trend. After that, traders wait for a reversal to enter in the direction of the trend at a more favorable price. These price corrections become smaller or even disappear when everyone wants to buy a lower open or sell a higher open until you have the ultimate blow-off and a reversal of a major bull or bear market. The dynamic end of a prolonged move is generally credited to the entrance of the public; when the masses are unanimously convinced that prices are going higher, who is left to buy?

The other important ingredient for a contrarian is that all the facts cannot be known. The widely accepted belief that "prices will go higher" must be based on presumptions; if the final figures were out, the market would adjust to the proper level. This idea is older than The Art of Contrary Thinking. In 1930, Schabacker discussed cashing out of a long position if the market rallied on news that was general rather than specific.

The practical application of the theory of contrary opinion is the Bullish Consensus13 and the Market Sentiment Index, created from a poll of market letters prepared by the research departments of brokerage firms and professional advisors. In the Bullish Consensus (see Figure 14-5), these opinions are weighted according to the estimated circulation of these letters until a final index value is determined.

Sum of (each source x its relative weight x opinion)

Sum of (each source x its relative weight x bullish opinion)

The value of the Bullish Consensus will range from 0 to 100%, indicating an increasingly bullish attitude; Because of the bullish tendency of the novice trader, and the long-term upward bias of the stock market, the neutral consensus point is 55%. The normal range is considered from 30 to 80%, although each market must be individually evaluated.

Hadady also devised a simple mathematical way of displaying the bullishness of the market.14 Using the formula below, he shows that when 80% of traders are bullish, then the average buyer will hold only '/< the number of contracts as the average seller. This leads to a precipitous drop in prices once a decline begins.

20%TxNs 1

where T= the number of traders in the market

N, = average number of contracts held by a single bullish trader Ns = average number of contracts held by a single bearish trader

" For the most definitive works, see Humphrey Neill, The Art of Contrary Thinking (Caxton Printers, Caldwell, OH, 1960), who is credited with having first formulated the concept, and R. Earl Hadady, Contrary Opinion (Hadady, Pasadena, CA, 1983).

13 The Bullish Consensus is a product of Sibbett-Hadady, Pasadena, CA; a Market Sentiment Index is published in Consensus, Kansas City, MO.

14 R. Earl Hadady, "Contrary Opinion," Technical Analysis of Stocks & Commodities (August 1988).

FIGURE 14-5 Interpretation of the Bullish Consensus.

Bullish

Consensus

Percentage

An important downtrend in the price is imminent.

Indeterminate area—an important downtrend in the price could start in this area. The change in trend in the Market Vane Consensus should be used, along with technical analysis, to determine the top.

Odds favor the continuation of any existing uptrend in the price. If prices are not in an uptrend, subsequent action is indeterminate, unless a bottom seems to have formed. In that case, expect new lows because the majority cannot be right at a bottom.

Odds are even for the price to move In either direction. Do not take a position. 55 percent is the norm or equilibrium point, due to the normal bullish bias of the public.

Odds favor the continuation of any existing downtrend in the price. If prices are not in a downtrend, subsequent action is indeterminate, unless a top seems to have formed. In that case, expect new highs to be made because the majority cannot be right at a top.

Indeterminate area—an important uptrend in the price could start in this area. Hie change in trend in the Market Vane Consensus should be used, along with technical analysis, to determine the bottom.

A major uptrend in the price is imminent.

Source: R. Earl Hadady, Contrary Opinion (Pasadena, CA: Hadady, 1983). ^

The principle of contrary opinion does not require that trades only be entered in the direction opposite to the current price movement. Within the normal range, the contrarian will take a position in the direction of the trend. Frequendy, the Bullish Consensus will begin increasing prior to the price turning higher, indicating that the attitude_of the trader is becoming bullish. It is considered significant when the index changes 10% in a 2-week period. Once the Bullish Consensus reaches 90% during an upward move, or 20% during a bear move, the market is considered overbought or oversold, and the contrarian looks for a

Bullish

Consensus

Percentage

convenient point to exit from the current trade. Positions are not reversed until prices show that they are not continuing in the original direction. This could be identified using a moving average. Remembering Schabacker's advice, the occasion of a general news release that moves the market further in the direction of the general opinion would be an opportune moment to enter a contrary trade; specific news that fails to move prices would be a good indication of an exhausted trend when the consensus is overbought or oversold. A typical contrarian situation identified by Hadady is given in Figure 14-6.

R. Earl Hadady said: "The principle of contrary opinion, by definition, works 100% of the time. The problem is getting an accurate consensus."15 Timeliness is a problem with this index; if 60 to 70 market letters are reviewed, read, and weighted to form an index, the results may be outdated before they can be used. The theory of contrary opinion also emphasized its use as a timing device for entering trades at an opportune moment and for filtering out the ambiguous trades; the theory is not readily applicable to exiting a position unless the reverse consensus occurs. Because a consensus does not have to switch uniformly from bullish to bearish, it is not always prudent to wait for an opposite confirmation before exiting a trade.

Commitment of Traders Sentiment Index"'

The reported positions of traders, published in the CFTC's Commitment of Traders Report, may be considered a recording of market opinion into categories. By combining

15 George Angell, "Thinking Contrarily," Commodities (November 1976).

16 Stephen E. Briese, "Commitment of Traders as a sentiment index," Technical Analysis of Stocks & Commodities (May 1990).

15 George Angell, "Thinking Contrarily," Commodities (November 1976).

16 Stephen E. Briese, "Commitment of Traders as a sentiment index," Technical Analysis of Stocks & Commodities (May 1990).

Steve Briese Cot Report

the idea behind the stochastic calculation with a method originally developed by Curtis Arnold, you can create an index:

current net - minimum net

Commitment of Traders Index --

maximum net — minimum net where: Net = Commercial net position (number of contracts) minus the total com bined net position of large speculators and small traders Maximum = Greatest net difference that occurred during the comparison period Minimum = Smallest net difference that occurred during the comparison period

The intent of the Commitment of Traders Index is to rank the current spread between the commercial and speculative positions within the context of the historic range. There seems to be uniform agreement the commercials are the group that determines the direction of prices. A shift in the position of the commercials should be closely watched.

Put-Call Ratios

The ratio of put option volume to call option volume, called the put-call ratio, is the major sentiment index for listed options. It too is used for its contrary value. The interpretation of extreme levels of the put-call ratios (in particular, the index option) points out a problem that may reflect on the proper use of all contrary indicators.17

Prior to 1986, the market was considered ready for an upturn when the total put volume exceeded 65% of the total call volume. Similarly, when the put volume fell to 35% of the call volume it was a bearish indication. In the volatile markets of 1986 and 1987 these levels proved to be far too close, and as McMillan said, "Not surprisingly, the put-call ratios fell into some disfavor at that point." This could easily happen with a contrary indicator, or any indicator that rarely reaches its extreme values. Because contrary opinion is a valuable addition to analysis, use of these indicators now focuses on relative highs and lows. This can be accomplished by smoothing the ratio using a standard moving average or momentum indicator (a simple difference over «-days). When the ratio moves over 65% and turns down it is time to sell. Such an approach gives up a timing edge but gready reduces risk and increases reliability.

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