New Single Day High in ISEE Equities Only Index on Monday

Lost in all the hoopla over the VelocityShares Daily 2x VIX Short-Term ETN (TVIX) was a historic event in the options and market sentiment world on Monday: a new single day high in the ISEE equities only call to put ratio.

To recap for those who may not be familiar with the ISEE, this ratio was developed by the International Securities Exchange (ISE) and is calculated by dividing opening long call options bought by ISE customers by opening long put options bought by ISE customers, then multiplied by 100. The ‘equities only’ slice of the full transaction pie means that all trades with indices and ETPs are excluded from this data, which also reduces the likelihood that any of the ISEE equities only data includes trades intended largely as portfolio hedges.

Monday’s record close of 410 means the ISE customers were buying four times as many calls as puts. Because there tends to be a lot of noise in the daily data, I like to average the data over a 10-day period. The chart below shows the ISEE equities only index since July 2011, along with the 10-day moving average.

Generally, put to call data is considered to be a contrarian indicator that flags when the masses are becoming overly exuberant or fearful and on Monday at least, exuberance – rational or otherwise – was running rampant, perhaps over the excitement of growing evidence of possible QE3 activity and a Bernanke put in general.

For what it is worth, the prior single day high in the ISEE equities only index dates from December 2010, when stocks were in the middle of a six-month bull move that resembles the current move in several respects and carried the SPX from 1039 to 1344.

Related posts:

• Yesterday’s Unusually Low ISEE Equity Number
• Checking for Athiests
• Equity Put to Call Ratio Hits Ten Month Low
• Chart of the Week: Total Put to Call Ratio
• CBOE Equity Put to Call Ratio Poised to Print Warning
• A First Look at the ISEE
• A Sentiment Primer

[source(s): International Securities Exchange]

Disclosure(s): short TVIX at time of writing

Intrade Prediction Markets as a Sentiment Indicator

Intrade.com is a fascinating place to park your brain from time to time. At this prediction market site, users can buy and sell binary options contracts that allow them to place bets on whether a future event will happen. Intrade has a broad range of contracts that cover everything from whether Osama Bin Laden will be captured by a particular month, which country will host the 2016 Olympics, what the year’s snowfall will be in New York City, and a wide variety of bets about the US election.

Prediction markets have received considerable press and academic attention for their purported ability to provide a better predictive view of the future than that of individual experts. Evaluating the arguments on both sides of this issue is beyond today’s scope, but those who are interested in reading about these claims may wish to start with Prediction Markets: Does Money Matter? by Servan-Schreiber, Wolfers, Pennock and Galebach and move on to prediction markets as a proxy for probabilities in Interpreting Prediction Market Prices as Probabilities by Wolfers and Zitzewitz. For an excellent broad introduction to prediction markets, I recommend Prediction Markets, also by Wolfers and Zitzewitz.

Unfortunately, the volume of trading activity for the financial and economic prediction markets contracts are not as popular as those for politics and entertainment. I do think, however, that there is considerable potential value not only in establishing probabilities for future events, but also gauging investor sentiment. At the moment, the most heavily traded financial contract at Intrade is whether the US will go into a recession in 2008. I have included a chart of that contract, which goes back to August 2007, in the graphic below, which compares estimates of the probability of a recession with the SPX during the same period. While there is a very high negative correlation here (i.e., we have yet another contrarian sentiment indicator working), I find it particularly interesting that the expectations for a 2008 recession peaked just as the SPX was making its January bottom.

If only there were a little more volume in the financial contracts, I suspect there would be quite a few more gems to pluck from the prediction markets. Until then, they are still a great place to get a sense of what the odds are that Barack Obama wins the Democratic nomination or Barry Bonds will be found guilty of one or more of the perjury and obstruction charges he is facing.

Bullish TRIN as Year Winds Down

One indicator that I have yet to comment on in 2007 is the TRIN, also known as the Arms Index, after its inventor, Dick Arms.

The TRIN is calculated by first dividing the number of stocks that advanced in price by the number of stocks that declined in price to determine the Advance/Decline Ratio. Next, the volume of advancing stocks is divided by the volume of declining stocks to determine the Upside/Downside Ratio. Finally, the Advance/Decline Ratio is divided by the Upside/Downside Ratio. In mathematical terms, the TRIN looks like:

(Advancing Issues / Declining Issues)

────────────────────────────

(Advancing Volume / Declining Volume)

Like the VIX and put to call ratios, the TRIN is a contrarian sentiment indicator. Generally, a rising TRIN indicates increasing bearish sentiment and a falling TRIN reflects increasing bullish sentiment. I have included the traditional 1.2 and 0.8 thresholds as indicative of sentiment extremes. These are levels at which the probability of a market reversal increases.

Depending on their trading time frame, practitioners use different bars for the TRIN. In the chart below, I chose to use 60 minute bars over the course of a two month period to generate swing signals of the short to intermediate-term variety. For comparison purposes, day traders frequently use 5 or 10 minute bars. It is important to note that different length bars give very different signals and also usually require a rethinking of where one should place the threshold levels for market turns.

At the moment, the TRIN is generating a fairly bullish signal – certainly the most bullish signal since Thanksgiving, when the markets began a strong rally that surprised many who were not watching the TRIN closely.

I will have more on the TRIN in 2008.

A Sentiment Primer (Long)

A reader asked about how to get up and running with sentiment indicators, where to get data, what time frames to use, etc. Since this is not a subject I have broached here, let me use this opportunity to provide an initial overview of some of my thoughts on sentiment indicators.

In terms of context, I consider fundamental analysis, technical analysis and market sentiment analysis to be the three primary legs of the investment stool. I believe it is a common pattern for relative newcomers to the investing world to begin with a fundamental analysis perspective, start wondering why individual stock don’t move ‘like they should,’ then add some technical analysis tools. Often it takes awhile to get the hang of TA; once they do, most investors get blindsided when thee entire forest moves abruptly while they are focusing on an individual tree or two. This is often the catalyst that leads to a more in-depth examination of market sentiment indicators.

Sentiment as a Contrarian Indicator

With that out of the way, where should you start with investor sentiment? First, keep in mind that much of market sentiment is a contrarian tool. One of my favorite quotes comes from John Bender in Jack Schwager’s Stock Market Wizards, “It’s not the current opinion on the stock that matters, but rather the potential change in the opinion that matters.” When your great aunt, housekeeper and taxi driver all start telling you how much money they are making in the stock market, who is left to buy and drive prices up further? On the other hand, if most of the people you know confess to having recently lost over half of their money in the market and swear about “never investing in stocks again,” then the markets have probably just about run out of sellers.

By all means, keep tabs of anecdotal evidence from novice investors you know and consider how much easy money you could make by taking the other side of every trade that a novice investor makes.

Types of Sentiment Indicators

In a nutshell, sentiment indicators attempt to discern what unsophisticated investors are thinking, feeling and doing, then encourage you to take the opposite position when their fear or greed reaches extreme levels.

Some sentiment indicators are compiled based on a direct survey of investors to determine if they are bullish or bearish. Three of the more famous of these are Investors Intelligence, the American Association of Individual Investors (AAII) and Market Vane. Newer additions to the fold are Birinyi’s Blogger Sentiment Poll and LowRisk.com’s Investor Sentiment Indicator. Since we know that what some people say and actually do are often two very different things, much of sentiment analysis looks at the activity of supposedly unsophisticated investors in order to get a better sense of which direction they are leaning. The ISEE (call to put ratio) is one such measure of investor activity; the CBOE Equity put to call ratio is another; and the Public Short Sales data is another good data point. To the extent you are able to, use ratios and other tools to compare and contrast the actions of the ‘little guy’ with that of institutions.

Sentiment Data Sources

In terms of sources, StockCharts.com has a great (and free) Market Summary page that is an excellent snapshot of what is going on in the 100+ most important markets, sectors, countries, etc. Scroll down to the bottom two groups and you'll find many sentiment indicators I follow in the "Market Breadth" section. You may or may not already be familiar with the "Bullish Percent Indices" – if you aren't, these are something you should take some time to educate yourself on in the future. Each indicator has links to three kinds of charts – and if you click directly on the name of the indicator, you will pull up the default gallery view.

Another excellent free site with a different set of indicators can be found at Market Gauge - Today's Indicators. I keep an eye on the “Contrary Opinion” data, in particular. Note that each line has a chart link in the far right hand side of the page. You may want to also bookmark Market Gauge's Market Summary page. Finally, I only recently discovered InvestmentTools.com, which has some superb “Weekly Sentiment Indicators” as well as some valuable “Short Sales” data.

Two other recommended sources for market sentiment are Market Harmonics (consider the "Volume" and "Momentum" data at some point in the future too) and the "Power Tools" at SchaeffersResearch.com. Once again, start with the “Sentiment Data” section, but eventually look at the others as well. In terms of blog sources, HeadlineCharts probably does more with market sentiment than any of the others I read and TheSentimentals.com has as comprehensive a list of links to market sentiment data as I have seen. For a weekly recap of sentiment data and a commentary on what is happening in the world of sentiment and market internals, check out Fred Ruffy's "Sentiment Journal" column at Optionetics.com.

Whenever possible, I suggest you get data directly from the exchanges, such as ISEE data from the ISE and CBOE VIX data and CBOE Put/Call ratio data from the CBOE. You can download historical data from Yahoo in spreadsheet format for the likes of the VIX and many other indices. As a rule, you should try to get this same data from an exchange or web site dedicated to this index first and use Yahoo only as a last resort.

Sentiment and Time Frames

Regarding time frames, your typical holding period should dictate the time frames you look at. Are most of your trades day trades? swing trades of 2-10 days? have holding periods of 1-3 months? Maybe you trade in multiple time frames (dangerous and confusing at times, but ultimately not necessarily a bad thing to do.)

I have never seen anyone articulate this, but my personal experience is that the charting time horizon for support, resistance, moving averages, recognition of common patterns, etc. ought to be something on the order of 20-50x your typical holding period. Most of my trades are of the 2-10 day variety, so most of the charts I look at are in the 20 day to 1 year range. I like to look at charts of 2 years or more for historical perspective on candidates I have already screened and I sometimes to go down as low as 1 minute bars for intra-day charts to fine tune entries and exits, but for the most part, I live in the 1-6 month charting world. Typically the longer term charts identify the opportunity and the shorter term charts trigger the timing of the entry.

I rarely care much about intra-day sentiment and look at a lot of moving averages in the 5, 10 and 20 day range, sometimes up to 200 days/40 weeks. Your sentiment time horizon should probably match your overall charting time horizon, but I haven't found much bang for my energy/attention buck focusing on intra-day or even day to day sentiment movement. Look for some smoothing factor, such as simple or exponential moving averages, to help minimize the noise.

On-Line Resources and Books

Regarding books and other educational sources, I can't say I have any great ones up my sleeve.

As noted earlier, for an on-line source, StockCharts.com does as good a job as anyone in terms of education. I would definitely start with their Introduction to Market Indicators and go from there, perhaps backing up to their entire Chart School series. You should probably bookmark their Glossary for future reference too.

For a broad brush perspective on sentiment indicators, I highly recommend that you check out an excellent post by Barry Ritholtz of The Big Picture, "Contrary Indicators 2000 - 2003 Bear." You should also download the full PDF or Word document that he links to and study the analysis of various internal and external indicators, then look at some of these and how they performed in and around May-July 2006 as well as around February 2007 – or any other period you are interested in.

If you want a treasure trove of ideas on sentiment, I heartily recommend a visit to TraderFeed.com, where a keyword search on "sentiment" will provide you with many hours of reading from the archives of Brett Steenbarger. If this is news to you, then you just aren't paying attention...

I am embarrassed to admit that I have not yet bothered with the free trial of Jason Goepfert's SentimenTrader.com, but from what I have seen of his work, I would recommend you test drive his site with a free trial. At a minimum, follow the link above to see what sort of indicators he thinks are worth following.

The last time I did a summary of recommended investment books was about 9 months ago. I need to update that list and put it on the blog, but I can tell you that there is not a great book on investor sentiment in there. Gary Smith’s How I Trade for a Living is probably my favorite treatment of market sentiment. Though it is not on the above list, I thought Toni Turner did an excellent job with sentiment and many other topics in Short-Term Trading in the New Stock Market. For my money, Turner’s book is one of the better ones for a relative newbie, albeit with a definite short-term bias. Two other books worth checking out for their discussion of sentiment issues are Martin Pring's encyclopedic Technical Analysis Explained: The Successful Investor's Guide to Spotting Investment Trends and Turning Points and New Thinking in Technical Analysis: Trading Models from the Masters, a patchwork of ideas from many respected thinkers, edited by Rick Bensignor, which includes a chapter on sentiment by Bernie Schaeffer, "Enhancing Technical Analysis by Incorporating Sentiment."

Why an Entire Blog Dedicated to the VIX?

Someone has to be wondering about this, even if I haven’t been asked yet.

Here is the reasonably concise answer:

In December 2006, I began wondering when we were going to have a correction from the July rally (I’m still wondering) and set about to look at a bunch of sentiment and other contrary indicators that might support my case. One that particularly caught my attention was the VIX, not just because of the obvious negative correlation to the SPX (see graph below), but also because options are actively traded in the VIX and could provide a more leveraged play than say the QID in a nasty downturn. I did some Googling and concluded that if there are any VIX ‘experts’ out there, they are certainly not a publicity-seeking bunch.

So I download the VIX price history data to Excel and started playing around with it. I posted some observations on an InvestorVillage forum and decided that a blog would be a much more convenient way to archive my thoughts.

That’s about it.

I find it ironic that I now have a VIX blog and am now thinking regularly about implied volatility issues, as I am not an “options guy” per se, having traded almost exclusively equities for the past 20 years, with the exception of an occasional outright purchase of a call or a put, and a rare covered call play. Only in the past month have I made my first foray into (bear call) spreads.

So that is why I call this a “learning laboratory of sorts.”

Initially, I thought I might tackle a wide variety of sentiment-related issues, but since Zen’s Market Insights, HeadlineCharts, and others do such a good job of covering the waterfront there, is not a high priority for me at this stage.

I will, however, experiment with the “and More” portion of this blog soon enough. Hell, espn has never figured out what to do with the “e” at the beginning of their name, so I am not worried about how long it takes me to sort it out.

Thanks to all who have contributed here in one way or another.

As always, comments and suggestions are welcome.