Charting A Ridiculously Extreme Market, In Which The Dumb Money Is The Most Confident It Has Been In 5 Years

Tyler Durden's picture

One of the sad side-effects of taking away investment risk, as Ben Bernanke has done with his "global put" doctrine, is that the old maxim of the market staying irrational far longer than anyone can possible imagine, can now be exponented to some irrational infinite number (to throw some wacky number theory into the equation). Whether Bernanke can also succeed in defying nature and mathematics in broad terms remains to be seen: we have yet to see a system that can diverge from equilibrium in perpetuity without some very unfortunate unanticipated side-effects somewhere. Yet with the bulk of day-trading systems now primed to do nothing but chase momentum, this divergence could lead to unseen previously deviations. We are confident that while printing a reserve currency (whose reserve status is rapidly diminishing) is one prerogative that Ben has, changing the laws of thermodynamics is one field where Bernanke will fail. Nonetheless, in its attempt to destroy all bears, only to be followed by the annihilation of all bulls (as the TBTFs pocket all the margins, and capital gains) the market continues to be nothing less than a casino primed with far greater house odds than even the worst slot machines in Atlatnic City. And just like in AC, accrued profits are not real, until taken. And if taken one second too late, they merely become deferred losses. That said, we would like to present some very factual representations to just what extreme level the market has been overbought in this latest year end push to make hedge fund managers richer (who are the only ones who get to be paid at year end without booking profits, of course assuming they beat the S&P, which means about 33% of them). Courtesy of we can observe just how irrational the market has become... As to how much longer it can sustain this, feel free to address your questions to the Chairman.

First, we present the confidence of smart and dumb money. Never before has it been as self-gratifying for "dumb money" advocates (i.e., those who do nothing but "trade the tape") to exude a sense of complacent all-knowingness. After all, they will always be able to sell just ahead of the wipe out...

For those confused by what the distinction is, here is sentiment trader's explanation:

Generally, we want to follow the Smart Money traders – we want to bet on a market rally when they are confident of rising prices, and we want to be short (or in cash) when they are expecting a market decline.  We also call this measure the "Buy Confidence" indicator - it tells us how much confidence we should have in buying the market.

Examples of some Smart Money indicators include the OEX put/call and open interest ratios, commercial hedger positions in the equity index futures, and the current relationship between stocks and bonds.

In contrast to the Smart Money, we want to do the opposite of what the Dumb Money is doing.  These traders have proven themselves over history to be terrible at market timing.  They get very bullish after a market rally, and bearish after a market fall.  By the time the majority of them catch on to a trend, it’s too late – the trend is about to reverse.  That's why we call this the "Sell Confidence" indicator too, as it tells us how confident we should be in selling the market.

Examples of some Dumb Money indicators include the equity-only put/call ratio, the flow into and out of the Rydex series of index mutual funds, and small speculators in equity index futures contracts.

Our Confidence indices are presented on a scale of 0% to 100%.  When the Smart Money Confidence is at 100%, it means that those most correct on market direction are 100% confident of a rising market…and we want to be right alongside them.  When it is at 0%, it means that these good market timers are 0% confident in a rally, and we want to be in cash or even short when confidence is very low.

We can use the Dumb Money Confidence in a similar, but opposite, manner.  For example, if the Dumb Money Confidence is at 100%, then that means that these bad market timers are supremely confident in a market rally.  And history suggests that when these traders are confident, we should be very, very worried that the market is about to decline.  When the Dumb Money Confidence is at 0%, then from a contrary perspective we should be concentrating on the long side, expecting these traders to be wrong again and the market to rally.

In practice, our Confidence Indexes rarely get below 30% or above 70%.  Usually, they stay between 40% and 60%.  When they move outside of those bands, it’s time to pay attention!

Little to be added there.

Next up we look at the Options Speculation index, which, not surprisingly, is far beyond the highest it has been in the past 5 years, possibly ever.

While it is rather self-explanatory, here is the official interpretation of the chart:

The Options Speculation Index takes data from all the U.S. options exchanges and looks at opening transactions.

We total the number of transactions with a bullish bias (call buying and put selling) and also the number of those with a bearish bias (put buying and call selling).

The Index is a ratio of the total bullish transactions to the total bearish transactions.

The red and green bands on the chart are 2 standard deviations from the one-year average of the index.

Like most other put/call ratios, this is a contrary indicator, so when we see excessive speculative activity (i.e. the indicator moves outside of the upper red trading band), it means that traders are very confident of a rising market, and we usually see just the opposite.

When we see too much risk-aversion and the indicator moves below the lower green trading band, then we're at a pessimistic extreme and we typically see a market rebound shortly thereafter.

Next, we look at the Large Only, Buy to Open (L.O.B.O.) Put/Call Ratio:

This one is a little trickier, although as can be seen it too is at (at least) a five year high:

The LOBO ratio is made up of only large traders, those trading 50 or more contracts at a time.  Granted, with low-priced options, even a small trader could fit into this category, but for the most part these reflect institutional-type traders.

Because of that, there is an added complexity to the interpretation of this ratio.  The ROBO ratio is pretty clear - when small traders are buying puts, then they're bearish on the market; when they are buying calls, then they're bullish.

With large traders, they could be buying puts not only to speculate on a decline, but more likely as a hedge against their existing positions.  So when we see a large rise in put buying, it could actually mean that these traders are so bullish that they have bought a large amount of stock, and need to hedge against that.  And when they're buying a large amount of calls, it could mean that they have sold or shorted stock and need a hedge against a runaway upside market.

So the underlying reasons for high or low put/call ratios differ from the ROBO ratio, but fortunately when we look at the chart it doesn't make much of a difference.

On the chart, we show three indicators - the LOBO Put/Call Ratio, the percentage of total large-trader volume that went into buying call options, and the total large-trader volume that went into buying put options.

The guidelines are straightforward.  When any of the ratios move outside of the upper red dotted line, then we should look for the market to decline; when any move below the lower green dotted line, then we should look for the market to rally.

The euphoria is just as visible in the ISE Sentiment index:

The summary:

The International Securities Exchange (ISE) is an all-electronic options exchange.  It has been steadily gaining market share since its relatively recent formation, and in 2005 it often traded more options contracts than any other exchange, including the Chicago Board Options Exchange.

In its capacity as a leading options exchange, the ISE has a wealth of information at its fingertips.  In 2002, it unveiled a sentiment index based on the volume traded there.  As a potential improvement to the put/call data provided by the CBOE, the ISE created its index using only those options that are bought to open.  This gives us a more "true" feel for the sentiment behind the options trades, as the data is not skewed by large institutional options sellers.

The interpretation of the ISE Sentiment Index is very straightforward.  When it is high, it shows that customers have been buying a lot of calls options in relation to put options.  That means that they are likely making heavy bets that the market will rise.  Conversely, when the Index is low, it means that traders are buying relatively few calls compared to puts - a sign of pessimism.

Like all other contrary indicators, we want to look for higher market prices when pessimism is very high (coinciding with a low Index reading) and look for lower market prices when traders are very optimistic (i.e. when the Index is high).

As noted above, we should expect a market decline when traders are very optimistic.  Therefore, when the ISE Sentiment Index shows a daily reading of 250 or above (meaning traders are buying 250 calls for every 100 puts), or the 10-day moving average is 200 or higher, we should be cautious.

We are at 230.

And lastly, it is fair to point out that not everyone is betting on an infinite market increase. CFTC COT disclosed commercial Nasdaq 100 hedgers continue to be near their year's net shortest, even as the "coincident" small specs has rarely seen a more euphoric market: after all the Nasdaq is at December 2007 levels: what can possibly go wrong.

Another largely self-explanatory chart:

Commercial Hedgers - Commonly believed to be the "smart money", these traders are involved in the day-to-day operations of each commodity.  They have an excellent handle on the underlying market, and it typically pays to follow their positions when they reach an extreme.

Large Speculators - This group mostly consists of large hedge funds, and almost always take the opposite side of commercial traders.  The are primarily trend-followers, and will accumulate positions as a trend progresses.  When their positions reach an extreme, watch for a price reversal in the opposite direction of the existing trend.

Small Speculators - These are smaller traders, composed mostly of hedge funds and individual traders.  Again, they are mostly trend-following in nature and we often see price reversals (in the opposite direction) when they hit an extreme.

To make the chart quicker to read, we invert the indicator values on the chart, so that the equivalent of an "overbought" reading is at the top of the chart, and the equivalent of "oversold" is near the bottom.

When Commercials become net long to an extreme degree (i.e. below the green dotted band), then we should be looking for the index to rise.  The opposite is true when they become so hedged that their position goes above the red dotted band.  These commercial traders have been especially active and useful in the Nasdaq 100 futures over the past several years.

You also want to look at the absolute level of positions, too - if they're at their greatest extreme in several years (even if they may not exceed the trading bands), then there's no question we're seeing a notable event.

As always, we merely bring you the facts. If readers wish to go against the grain of the broader public which has now decided to end its affair with stocks (at least for the time being, as demonstrated by 31 consecutive outflows, and not even closely matched by ETF inflows, a fallacy we debunked some time ago), and join the "dumb party's" money, no matter how short- or long-lived it may prove to be, they are now aware what the market reality is. And hopefully, they will also realize that a 50% rise in notional stock prices coupled with a 50% drop in purchasing power ends up being a loss any way it is perceived. But then again, they are called "dumb money" for a reason...

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
FunkyMonkeyBoy's picture

This time it's different!

MR. GLASS's picture

 “As long as the music is playing, you’ve got to get up and dance,. . .We’re still dancing.”  - Chucky Prince

Tense INDIAN's picture

"Chuck Prince said that you have to dance until the music stops, actually the music has stopped already"---George Soros (The inside Job)

Ludwig Van's picture


Tell that to First Violin Ben over there.


homersimpson's picture

I guess by the above definitions, Harry Wanger is classified as dumb money (but we knew that already).

HarryWanger's picture

Rather be "dumb money" making nice returns than "smart money" losing their asses digging for any morsel of data mining to make their case for a pull back. Right, Nic?

tmosley's picture

He's up until he's bankrupt...AGAIN.

4xaddict's picture

only nice returns when you've banked them Harry! If you have though, congrats! Can't say I share your overall bullish attitude but if you can get in and out without getting your ass burned then good luck to you!

MarketTruth's picture

Just buy the fuckin' dip! Are you stupid or something, just buy the fuckin' dip!!!!!!!!!!

BotanyBabe's picture

Can BroccoliMan stop inflation in 15 minutes?

I Am The Unknown Comic's picture

you betcha! ...and with 100% CONfidence

redwraith's picture

Would I still be considered "dumb money" if I side with "dumb money", but make money anyway?  Or would that make me "smart money" being able to play with "dumb money" and still be profitable?

It's probably just dumb luck.

I Am The Unknown Comic's picture

....hmmmm.....maybe you're not as think as you dumb you are

no life's picture

When this is all over, a T-shirt shall be distributed to all citizens.

We got that going for us, which is nice.

tmosley's picture

Yup, we all get to share one t-shirt.


total nonsense's picture

I wonder if anyone is noticing all the "special" cash dividends being paid out so insiders ca cash in before either #1 the tax laws change or #2 the easy money days are over. The great ponzi scheme continues. Thank You Ben Bernanke for bailing out the Rich

rocker's picture

Isn't that who the FED are. The rich elite bankers. Who would expect anything different. Rinse and Repeat. 

Sudden Debt's picture

It looks like the banks might indeed push the markets higher this week.

BAC and C both broke resistance levels and could now go another 5 to 10% higher these next 2 weeks. And those 2 will lead in volume and push all the markets up.


Ferg .'s picture

Very insightful information . Merely solidifies my opinion that we are about to see a fairly deep decline in equities ( only question that remains is if it will begin before Christmas or at the start of 2011 ) . I've been reading nothing but positive articles about stocks . As a contrarian this , plus the slew of bullish sentiment data ( to say nothing of the awful awful state of the US economy ) , is a clear signal to prepare to enter a few shorts . Of course given the fact that this is a market glued to an upward bias , you can never be sure ...

Chartist's picture

There seems to be a contradiction here.  How can money continually be pulled out of funds by retail investors (read dumb money) yet the current environment indicates so-called dumb money shows highest confidence level in last fiver years.

hambone's picture

I don't think money is being pulled due to lack of confidence...I thinks it's a lack of money!  Folks out of work, folks working but not contributing, and folks in retirement starting to pull.

Adds up to outflow.

Paladin en passant's picture

Two different sets of folks.  Fund buyers are trying to sock away some bucks for retirement, kids college or that dream vacation home in Belize.  They wouldn't buy an option if you paid them to take the risk. Small-lot option buyers believe they are the next George Soros or Jesse Livermore.

I need more cowbell's picture

Excellent comment, made me think. I think J6P is out and on the sidelines pretty much for good, so the dumb money has to be the remaining few, who are traders anyway and not buy and hold mutual fund owners.

My take for what it's worth.

TraderTimm's picture

For now, my prop indicators say higher. Of course, the corollary is when they do not. I very much look forward to a proper decline. Devil is in the details, after all.

Apart from Reality's picture

The Fed money is definitely buying, not sure whether that is best described as Smart, Dumb or Dumber.   It is certainly skewing all the normal indicators though.

Ludwig Van's picture


We're in the cartoon phase of blood, famine and plague.


Dismal Scientist's picture

The Bernank put will work, until it doesn't. As always, diversification is key, which means own physical assets as well as paper assets. What percentage mix works for individuals is their own concern. As long as the Fed (dumbest money of all, were it not for the fact that its taxpayer money, so yes, its still the dumbest money) props up paper assets, then expect to see continued new highs in equities. Most of the strategy pieces I have seen for outlook 2011 say 'switch into equities from bonds', this is fast becoming the new consensus.

Its a liquidity driven environment still. Play at your own risk...

Joesmoe's picture

WHo in the world knows.


I am betting on a correction when the next round of politicians step in mid January.

RobotTrader's picture

Tough call.  Seems like when we reach these levels in sentiment, the market is ready for a quick drop, just when everyone leasts expects it.

But we also have some key big caps breaking out, showing signs of strength.


David White talks about the "once in a lifetime opportunity" to buy puts in the options market:


O'Brien has been calling for a crash to SPY 825 for over 3 months now:


Kaltbaum disagrees.  Says market is due for a correction, says he's getting flooded with e-mails from guys
who want to short.  But doesn't see any real signs of a major drop or signs of market weakness yet.


Spalding_Smailes's picture

--- ( CHNG ) ---

--- ( BJGP ) ---

--- ( NPD ) --- China Nepstar Chain Drugstore Ltd.- retail drugstore chain in China store network was comprised of 2,479 directly operated drugstores the Company had developed 1,524 private label products.( $ 3.47 )

DoctoRx's picture

Not a junkable comment from Robo IMHO.  Lowry's increasingly bullish.

On the first chart re dumb/smart $$, it looks as though "dumb" money was much smarter than "smart" money all throughout 2009, and at other times.  

I'd prefer to look at the fundamentals rather than try to discern who's thinking, saying or doing what.  Ultimately the only thing that matters is price.  And, e.g., AAPL and HP (not HPQ) are solvent and thriving, whereas the govt is not.  So, $$ does have to go somewhere . . .

Trifecta Man's picture

Traditional support for the bear case also may include the Investors Intelligence Bull/Bear Sentiment Survey,

For some perspective, click the 2 Years link.

The wide spread of Bulls over Bears also can be taken as a contrary indicator that the Bulls are fully invested.

Without the Fed's easy money, the stock market would ordinary be a high risk proposition at these levels.  But since the easy POMO money is a given, it matters what assets will attract the future money.  Bonds are sinking in price as interest rates go higher.  The JP Morgue has yet to capitulate, so gold and silver may still attract more money.  Cash may be okay because the dynamics for the euro suck.  Commodities are still a preferred play.  No slowdown there with all the money printing around the world.  Then there is stocks.

My guess is that we see more sector rotation in stocks, not a crash just yet.

Ludwig Van's picture


If the Bernank stands as a proxy for *Brilliant* Money (BM, aka Fat Boys), i.e. smarter than Smart, then the acts of BM (who wants it *all*) expresses there's still more out there to suck up. The retail trade means nothing anymore, and hasn't for awhile. But the commercials, the original Smart Money standard -- those guys still have something. Six months or a year (or whatever it takes) of POMO to lure them out is small price for big game, especially if you can take over their turf.

The best way to get to a guy is to fuck with his head, make him think he's going nuts, or goad him to trespass against his better self (cf. Winston Smith). These strong, if sub-elite, investors, underwriters and market makers constituting Smart Money represent the thinning wire strand of substance remaining in this nation, proxy for the middle class, meaning the last and most formidable barrier to the Fat Boys getting it *all.* Therefore they've got to go.

At cartoon extremes of market contortion, where bad news brings rejoicing for increased welfare, and good news is a bummer because in a healthy recovering economy I'm gonna hafta go back to work; when down is up and wrong is right (those rich lying bastards are surely blessed!) -- what place does due diligence, technical analysis or market sentiment have in that world?

A simple ambush won't work on Smart Money; they're ready for that. But a slow, steady grinding down... or up?

Dow 20K, S&P 3000, Nas 10K -- why not? I mean, if you're gonna crash the bus, buddy, don't run it off the road, but off a cliff.

You see, just as the Fat Boys (aka BM) have had us occupied all along in dualistic Democrat-Republican spats, so that worked so well for so long we'll start seeing that principle applied in all kinds of ways, i.e. Smart Money-Dumb Money.

*Illegitime carburendum.* Don't let the bastards grind you down.



something fishy's picture

How does this mesh with the continuing retail outflows from equities? Also,

it looks like the 'smart money' was way too bullish throughout 2008, more so

than retail. It seems like 'smart money' isn't that smart after all.

Dinghy Dumper's picture

"changing the laws of thermodynamics is one field where Bernanke will fail"

Thermodynamics indeed !

Whenever one relies on an exponential growth function that ultimately has to couple to actual mass and energy flow in any system (a.k.a. "the real economy") the system has to crash.

See e.g., here for a nice little take on that.

TheGreatPonzi's picture

The men who shorted the Zimbabwean stock market went broke.

It will be the same here. If investors sell, the FED will buy.

Do you seriously think the FED will accept a stock market crash?

erik's picture

They didn't stop 2008 crash from occurring.  Or are you saying that they will not allow any future stock market crashes?

The stock market is less important to the Fed than the bond market.  If it weren't, the Fed would be purchasing stocks and not bonds with QE.

Isn't Zimbabwe a poor example?  The US has debts denominated in its own currency, Zimbabwe had debts denominated in dollars so they had to print their own currency to buy US dollars.

badnews...buyspus's picture

They DO buy the equity market everyday - they just don't and won't admit. Not only do they buy SPY outright but they also have their big 5 banks buy with the money they funnel through daily (QE). The equity market is their focus as they believe in the same bs of trickle down economics.