Traders are facing increased volatility in the markets these days. Wouldn’t it be nice to have an extra odds enhancer that could help you identify when there is a higher probability of a rally day or a pending sell-off? As traders, we look to the mistakes that novice traders and investors make and try to take the opposite side of the trade from them in order to profit.
One of the ways we can identify those mistakes is by observing when extremes have been met in sentiment. Usually, when everyone who wants to buy has entered a bullish position in the markets, the demand has been satisfied and it will be extremely difficult for prices to continue to rise. This may lead to a sell-off that triggers stops and accelerates downward.
The same phenomenon occurs after a panic sell-off. If everyone has dumped their supply on the markets at about the same time by selling or shorting, then the markets will be exhausted of that supply and start to rise as bargain buyers step in. The rise in price triggers a short covering rally, or remorseful sellers repurchase shares, thus fueling the rally.
One of the ways we can measure extremes in the equity markets is by viewing the put/call ratio. The Put/Call ratio has long been used as a sentiment indicator to gauge whether investors and traders were becoming too bullish or bearish on the markets. If too many people were buying puts over calls, then the stock may be oversold and poised for a bounce.
The International Securities Exchange (ISE) has an indicator that we can use. The ISE Sentiment Index is a sort of Put/Call Ratio with a twist. The ISEE goes a step further and only counts NEW puts and call positions being opened by small investors and traders. It ignores currently open positions to find the current sentiment in real time. The ISEE also filters out institutional positions so the data does not become skewed by them, hedging positions instead of taking advantage of a potential market move. Remember, an institution buying puts may not be bearish now, but wants to protect a major long position, or may even sell calls to reduce cost basis.
The majority of “dumb money,” small investors, traders, people we know as the herd, is usually wrong at major turning points. We can use the ISEE to determine when the bullish or bearish “dumb money” sentiment has become so great that the market may be at a turning point. If the ISEE closes at an extreme level, it usually marks a reversal point in the market. Remember, it may not be immediate, but it usually occurs shortly after the extreme, unless prevented by Fed actions, major news effecting the market, or acts of terrorism.
In order to read the ISEE, you will go to the International Securities Exchange website at www.ise.com. The ISEE is found by clicking the link on the picture on the home page.
To filter out ETFs that profit from inverse movements, we will look to the middle section which is labeled “All Equities Only.”
The low level reading is a close below 100. Remember, the intraday data is nice, but the closing value is the most important. If you see a close below 100, expect a broad market rally within three trading days. The high reading is 200. If you see the closing value on a given day is over 200, expect a sell-off in the markets within three trading days. Pretty simple, isn’t it? I wish it were. While the index can work well, we must never deviate from our studies of supply and demand to drive our trading decisions. The ISEE can give false signals as any other indicator is likely to do.
Well, there are some related articles on how to use the indicator in a more advanced manner on the ISE website. You can also go to the Market Data and Trading Tools tab on the left of the site and see more information on the ISEE. You can even get a chart of the index including moving averages.
Looking at the ISEE Index’s performance for the past year, it closed above 200, twenty times. Of those, only three readings failed to produce a market drop within three trading days. On the bullish side, the index closed below 100 only five times. Four of them did have a price rise in the S&P 500 within three days.
So this may serve as a warning for price action for both swing and day traders. It is not perfect, but can let us to know what to expect in out trading.