How retail investors survive in the stock market by applying ISE index

Market sentiment indicator ISEE

The International Securities Exchange (ISE) was founded in 2000.  It is a platform to trade varieties of equity and index options. 

          Options trading volumes and patterns have been analyzed to comprehend the market sentiment which helps in making wise trading decisions for trading for many years. An eye catching technical indicator ISE sentiment Index (ISEE) might be the most popular and effective one in this area. 

Why ISEE data only focus on retail investors’ options transaction

The ISE Sentiment Index is calculated as the ratio of call option volume to put option volume, and is normalized by multiplying 100.  Here is the formula

ISEE=Opening Calls /Opening Puts x 100

This quantitative measurement filters out the transactions made by market makers and financial institution firms which are involved in  hedging, asset protection, or other elaborate schemes instead of pure speculation. 

Please keep in mind, the money makers and large institutions purchase put options in order to protect a large amount of long positions, and reduce cost basis, rather than take advantage of speculating on market movement. 

According to Barron’s, the ISEE data focuses only on calls and puts transaction amounts made by retail investors, such as individual investors, money managers, and hedge funds managers, etc.  Therefore, retail investors’ transaction patterns and behavior is believed to be able to determine the market sentiment from an expert’s view. This is due to the fact that the data is not significantly skewed by a large quantity of options traders or money makers.

The ISEE usually goes conversely with the stock market

S&P from 7/11/2011 to 7/31/2013

Source: Line Graph Outline from Yahoo Financial.  Actual data compiled by Authors.

The market usually goes the opposite way of the ISEE reading. We are not saying it works 100% of the time. However, if the reading appears to be out of the box, it is definitely a red flag to watch, especially when you combine this information with other indicators to find out the market is in overbought territory.

Generally speaking, the bullish sentiment is often accompanied by exuberance and greed. Bearish sentiment is coupled with fear and regret. Often, both psychology and perception distract investors from successful investment.

Only if you know yourself and your opponents very well, can you win the battle.

Sun Tzu said in The Art of War, “Only if you know yourself and your opponents very well, can you win the battle.”  Otherwise, you are like a turtle trapped in a jar.  On the other hand, the money makers and fund managers are watching keenly the options trading level. It’s not totally clear what percentage of retail investors are aware of this indicator ISEE.  The money makers can utilize the ISEE as a weapon to attack the retail investors and skim profits. You have to be daring opposed to the retail investors. 

                Source from wikiquote.com

Pessimism is your friend, and euphoria is the enemy

On July 3, 2009, in a CNBC interview, Warren Buffet once said, “In investing, pessimism is your friend, euphoria is the enemy”.

The logic behind the ISEE index is that inordinate orders placed for either calls or puts underlines the ultimate levels of optimistic or pessimistic judgment.  Generally speaking, the overwhelming bullishness usually foretells an overcrowded market condition.  The market becomes vulnerable (weak) and even dangerous!

                   Source from mentalgamefish.com

How to control fear and greed

Generally speaking, the bullish sentiment is often accompanied by exuberance and greed. Bearish sentiment is coupled with fear and regret. Often, both psychology and perception distract investors from successful investment.

Source from leadingtrader.com

          When the ISEE reveals the extreme bullishness, we as investors had better control our greed. On the other hand, if the ISEE exhibits the extreme bearishness, we should get rid of fear and be bold.

          As retail investors, we can treat the ISEE as a practical tool with which to comprehend the sentiments of our investor peers.  Keep in mind, however, our peers’ viewpoint might be deemed as a contrarian one, and we might want to think and trade like a professional trader. 

          Are you fearful or greedy about the current market?