Sentiment indicators focus on investor expectations or their degree of bullishness or bearishness about a particular stock or stock index. At first, it might seem that if a sentiment indicator implied that investors were bullish about a stock, it would be an excellent time to buy it. Sentiment indicators are almost always used as contrarian indicators.
A contrarian indicator suggests buying a stock when most investors are bearish and selling a stock when most investors are bullish. In other words, if most investors feel strongly that prices will rise, contrarian investor behaves as if they will fall. The rationale is that if most investors feel that prices will rise, they probably own the stock already, so not enough is left to push prices significantly higher.
Contrarian indicators are usually used as corroborating evidence to support other technical indicators. Various tools can measure overall market sentiment, including the put/call ratio and public short ratio.
The put/call ratio compares the number of put options traded during a trading session with the number of call options. Put options can either speculate on a price decline or prevent or limit losses (or protect profits) on a new or existing position. On the other hand, call options can be used to speculate on a price increase. Therefore, the number of put options traded relative to the number of call options traded (the put/call ratio) can indicate the degree of bearishness among investors. If the ratio rises (the number of puts traded increases relative to the number of calls traded), it suggests a bearish market sentiment.
Since the put/call ratio is used as a contrarian indicator, bearish market sentiment is considered a bullish indicator. A falling put/call ratio suggests a bullish market sentiment, and a contrarian indicator would be considered a bearish indicator.
When the put/call ratio reaches extreme levels, the market is considered to be either overbought or oversold. What constitutes extreme is a matter of interpretation. If put/call ratios are usually around 60%, then a ratio of 80% could indicate overly bearish market sentiment, while a ratio of 40% could indicate an overly bullish market.
Public Short Ratio
Some exchanges publish data on the total number of shares sold short, separated into two categories: those sold short by stock exchange members and those sold short by the public. The basic premise is that the public is a less credible short seller and tends to be wrong, particularly at market turns.
The public short ratio (PSR) divides the total short sales of the public by the total short sales. Public investors are more pessimistic about future market gains relative to member firms when the ratio is high. If the PSR is high and public investors are more pessimistic, then, as a contrarian indicator, this is thought to be bullish and suggests substantial market gains in the future.