“Be fearful when others are greedy, and greedy when others are fearful.”—Warren Buffett
There are a lot of measures reflecting the market sentiment. One of the measures I prefer is the call-to-put ratio. It indicates the proportion between all the call and all the put options purchased on any day.
In practice, I like to wait for very high indications of fear (Put-buying massively dominates when fear comes into decision-making). As soon as everybody is hedged and “weak hands” sold/reduced their equity exposure, the market suddenly turns. After a big bounce, people start to feel comfortable again and take their hedges off, which fuels the rise of the market further.
I developed a proprietary indicator called “Fear-to-Greed,” based on the above mentioned call-to-put data. Readings close to zero indicate fear and a possible reversal setup, whereas close to 1 signals indicate that people are getting greedy.
Test results show that buying on fear and holding for 2-3 weeks is indeed a winning strategy in the S&P500 over the last 15 years. The strategy is far from being perfect with a Sharpe ratio of 0.65. However, combining different tools and applying them properly, depending on the market regime, helps you make better decisions.
✓ Former hedge fund portfolio manager/trader
✓ 15 years of experience in financial markets
✓ Master of Science (MSc) in Business and Economics from the University of Basel
✓ Developed quantitative tools for an asset management