How You Can Profit Betting Against Market Sentiment

Dear Penny Sleuther,

On Monday I discussed with you how binary options were the easiest way to tap into fast gains in the currency market. Today I’m back to show you some specific ways to predict the movements of currencies…

As you know, successful investors use market sentiment as an indicator of how the market is going to perform in the future. What most people don’t know is sometimes betting against market sentiment can provide fast, substantial gains.

On November 1, I saw that market sentiment was leaning towards the US dollar outperforming the Swiss Franc. With the upcoming elections I told my readers that they should ignore the sentiment and bet that the Swiss Franc would surpass the US Dollar by the end of that week. Those who participated in the trade booked 545.2% gains. But while those gains are sizable, they’re only part of the story — let me show you how I  predicted that move, and how you could spot the next one…

It is becoming more important than ever for traders and investors to know how to track sentiment. The globalization of the world economy has increased complexity, as well as uncertainty, at all levels of investment. All this is reflected in the correlations between different markets. An event-risk in one market quickly cascades in other markets.

For instance, when the North Koreans initiate an aggressive move, the yen weakens; when the Irish run into financial trouble, the euro weakens and risk appetite around the world shifts into risk aversion. The challenge is to be able to detect both direction and points of inflection in global sentiment.

There several tools I often use to judge this, the two I will go over today are tracking Internet chatter and assessing option opinion.

Internet Chatter

The technique I use for gauging investment sentiment is to scan the headlines on the net and use search engines to track key opinions. Checking the Financial Times is certainly at the top of my must-do checklist. But that’s certainly not the end of my search.

A virtual “blogosphere” has developed that offers other sources of sentiment. Navigating these blogs can be tricky though, because it’s a mix expert and novice opinion. In other words, it’s less reliable as a sentiment signal source.

That may change, however. A new level of sophisticated text mining software is appearing that scans the Internet, reads millions of documents and texts in microseconds and produces sentiment maps. I am actually reviewing some beta versions now and will talk about them in the future. For now I just want you aware of this cutting-edge style of analysis.

Option Opinion

As I begin closing in on a trade, option opinion becomes very important. As you know, calls are bullish and puts are bearish — but the ratios of the prices between calls and puts generate very useful information.

For instance, you can compare the premiums of puts and calls with the same strike price and expiration date. If puts are more expensive, the market sentiment is more bearish. I also scan the risk reversals and volatility surfaces. These generally compare the premiums charged for puts and calls along different periods of duration. These are not common tools available to the retail trader.

As the week begins, I look at the ultimate sentiment indicators — the weekly binary options themselves.

As we discussed in Monday’s Penny Sleuth, Binary options are bets that the currency pair I’m looking at will be above or below a certain strike price by the end of the week on Friday at 3 p.m. It is a straightforward fixed dollar bet. If the trader is correct, the payoff is $100 per unit. If the trader is wrong, the trader loses the premium they was paid to play.

But the key here is that, in-effect, the premium prices being offered are market sentiment probabilities! By looking at the premium prices on the weekly binaries, I determine the geometry of sentiment — areas where the market is extremely positive or negative.

Strategically, my objective is to get the highest returns, and that means taking contrarian bets. In other words, when the sentiment is over 80% in one direction — bet against it staying that high. The element of event risks and volatility become our allies, and reward the trade for being on the side of surprise.

Sincerely,
Abe Confas
Currency Trading Analyst for Penny Sleuth

December 10, 2010

How You Can Profit Betting Against Market Sentiment was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

This story was originally featured on Penny Sleuth.

Read more at Penny Sleuth

Source: