THE HAnDbook of TEcHnIcAl AnAlysIs23.3 Assessing Participant Actions
We can gauge the sentiment of the market by the participants’:■ (^) Participatory actions via the analysis of the flow of funds, open interest, and
trading activity
■ (^) Expectation via opinion polls
In this section we will be looking at some basic:
■ (^) Flow of funds data
■ (^) Open interest via the commitments of traders (COT) report
■ (^) Trading activity via the volatility based indices
(1) flow of funds data
Margin debt Margin debt is the amount of funds borrowed from the broker in or-
der to purchase more shares or positions. Unlike buying with cash, where shares may
be held indefinitely, buying on margin incurs borrowing costs and must inevitably be
liquidated to release the margin. The rationale underlying the study of margin debt
is straightforward. As the market rises, more participants begin to risk more capital
in the hope of making a substantial gain from appreciating prices. As the market
spirals upward, a wave of irrationally exuberant but under‐informed participants
starts to anxiously seek additional capital to fund more buying, which inevitably
drives up margin debt. The situation for the under-informed is further exacerbated
by the higher cost of borrowing caused by the higher interest rates that normally ac-
company market tops. Margin debt approaches extreme levels once all usable mar-
gin is utilized. This lack of additional funds gradually shuts off buying activity. As
such, excessive levels of margin debt are usually a precursor of potential market tops.
Unfortunately, the under-informed may also seek out less capital‐ intensive deriva-
tives like options and futures in order to continue to participate in the markets. These
derivatives offer lower margins, and some derivatives like leveraged ETFs, afford
traders and investors potentially more potential profit over the same period in the
market. Figure 23.4 depicts the behavior of margin debt with respect to the S&P 500.
We see that the market tends to top out in sync with margin debt.
In Figure 23.5, we observe margin debt reacting at the 50‐month four‐sigma
upper band, which represents points of overextension.
Cash/asset ratio This sentiment indicator tracks the ratio of all securities and
available cash over liabilities. Mutual funds will normally have less available cash
as the market tops as a result of buying more securities in a rising market to boost
portfolio performance. Hence the ratio generally tends to decrease in rising markets.
In declining markets, the available cash increases as various securities are liquidated
and buying wanes due to a lack of high‐performing stocks to invest in, on behalf
of their clients. The ratio therefore generally tends to increase in declining markets.
public Short ratio This sentiment indicator tracks the amount of short selling
by the public over the total short sales. It is a contrary indicator, since it tracks the