Getting Started With Options

Overview of Expectational Analysis

An Introduction to Expectational Analysis

The slightest edge. That's what every trader looks for. But there's no Holy Grail that guarantees success in trading and investing, and the fickleness of the market guarantees there probably won't ever be one. However, our unique methodology provides a leg up on the competition.

At Schaeffer's Investment Research, we've found an advantage in an area that until recently was generally considered nothing more than hocus pocus – sentiment. When combined with fundamental and technical factors (a 3-tiered methodology we call Expectational Analysis®), sentiment becomes a powerful tool for analyzing stocks, sectors, or the overall market.

What exactly is sentiment analysis and why do we consider it so important? Investor sentiment is simply the collective feelings, moods, beliefs, (and in some cases actions) of investors (from the smallest individual investor to the supposed "smart money" of institutions). The most accurate sentiment indicators generally reflect what a group of investors is actually doing as opposed to what they're feeling and saying, although the latter also has a degree of validity.

There's no such thing as an infallible indicator, and sentiment is no exception. But without a feel for the expectational environment surrounding a stock, analysis (be it technical, fundamental, or a combination) is simply not firing on all cylinders. Very often it's the expectational – or sentiment – backdrop that makes the difference between a good market call and a bad one.

For example, it can be a puzzle as to why a stock declines despite an earnings report that met (or even beat!) Street expectations, while another equity rallies strongly after simply meeting expectations. In this and similar situations, what could possibly be the explanation?

The answer is often contained in the differing expectations surrounding the pair of stocks prior to the event. In the case of the former stock, the sentiment may have been excessively bullish heading into the report, making the shares ultimately vulnerable to disappointment. There could have been a build-up of call options or a lot of anticipatory buying of the stock, which then becomes exhausted by the time earnings are reported. Such a high-expectation environment creates a heavy burden on the stock to issue a blow-out earnings report.

For the other stock, there could have been a prevalent concern about a company's fiscal health and some expectations that earnings might fall short of the mark. The result? Increased put buying and shorting activity, which is eventually unwound should the company exceed lowered expectations.

Why are expectations so important? Because the price of a stock represents investors' perceptions of reality and often these perceptions are excellent contrary indicators. A stock with relatively low expectations stands a good chance of rallying, as the price will rise from this artificially low level to one that reflects the "real world." Conversely, high expectations can put downward pressure on a stock, as the price adjusts itself lower from its unrealistic heights to better match reality.

Put another way, low expectations translate into potential buying power, as skeptical investors (and their money devoted to investing) wait on the sidelines, ready to bolster a stock's appreciation by buying up the supply from profit-takers. This excess demand drives the price even higher. On the other hand, high expectations usually mean that much of the sideline money has already been committed to a stock. Buyers are now scarce and selling will predominate on any perceived negative news, leaving the stock more vulnerable to a significant decline.

One of the most important tenets of our Expectational Analysis® approach is that the power of a contrarian indicator is much greater when the underlying sentiment runs counter to the direction of the stock. For example, pessimism would be an expected reaction to a downtrending market and would therefore not be a valuable contrary indicator. On the other hand, skepticism in a rising market is a powerfully bullish combination, as market tops are not seen until optimism reaches extreme levels.

Investors are normally quite bullish during bull markets and quite complacent and relatively lacking in fear on pullbacks in bull markets. It then becomes an art for the sentiment analyst to determine when this bullish sentiment has reached an extreme, at which point buying power will have become dissipated to such an extent that the market will top out. But when negative sentiment accompanies a bull market, the task of the "sentimentician" becomes much easier, as it is thus clear that buying power has not yet been dissipated and that the bull market has farther to run before potentially topping out.

True Expectational investing does not mean simply buying a stock or index because no one likes it. By some definitions, a "contrarian" investor would simply scoop up out-of-favor securities, but just because stocks are out of favor doesn't mean they are on the verge of a rally. In fact, negative sentiment is certainly warranted on poorly performing stocks or sectors, and if a stock is displaying weak price action, there may certainly be a reason for it. Negative sentiment alone is not enough to predict when a stock will turn around, and positive sentiment is not enough to gauge when a stock may start to roll lower. After all, even exceptionally depleted selling strength will keep a stock moving lower as long as it exceeds the comparable buying strength.

An objective look at sentiment indicators – including short interest, option activity, sentiment in the press, and analyst ratings – can add substantial value to traditional technical analysis, because sentiment extremes are not visible on the charts and can only be viewed and measured by a separate class of sentiment indicators.

A trend that is nearing its conclusion cannot be distinguished on a chart from a trend that has a long way to go in price and time. In fact, there is an old saying in technical analysis to the effect that "the chart looks prettiest just ahead of a top." But sentiment indicators can help you distinguish the pretty chart that is going to remain pretty from the pretty chart that is about to turn ugly.

In the papers, on the financial news networks, and on financial websites, the term "sentiment" is cropping up more and more frequently these days. We take this as a broad sign that analysts are finally beginning to admit that there is more to the stock market than just fundamentals and technicals – something Bernie Schaeffer has been shouting since 1982.

The true pioneers of Expectational Analysis®, Bernie and his research staff have tested and developed many qualitative and quantitative methods to evaluate sentiment. The distinguishing difference is that indicators used at Schaeffer's Investment Research do not reflect only the overall market, but individual sectors and stocks as well. Read on to learn about some of these sentiment indicators and how they can be used to improve an investor's trading results.

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