History has shown that when the herd
moves in one direction, it may be time to consider going the other way. Therefore,
the sentiment detection in the stock market becomes increasingly crucial in our
financial life. We are going to discuss some technical indicators which might
be helpful to investors and traders.
The ISE Index (ISEE) is our
favorite technical indicator to determine the market reversal. We have been tracking
this indicator since 2007.
Source from veenome.com
Extremes of ISE Index (ISEE)
We are not saying the retail
investors are always wrong about the market. However, the majority of “dumb
money” retail investors who are known as “the herd” are often times mistaken
about the major turning points.
This phenomenon is related to herd
mentality and herd behavior. More and
more experts and economists study Behavioral Finance to identify and predict
the rational and irrational behavior of investors. One way or the other, we can
identify this phenomenon by observing when sentiment extremes occur among
retail investors. Historically, extremely high or low ISEE values have been
quite bullish or bearish omens.
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!
How can the
ISEE tell about the market sentiment
When the ISEE reaches around 100
which is trend line, the sentiment is treated as neutral status. When the ISEE is above 100, for example 150,
it means for every 100 units of put option orders are there are placed, and 150
units of call option orders are placed during the same time frame. This case shows that investors are optimistic
about the market. The higher the ISEE
reading, the more bullish the market sentiment is deemed to be. Conversely,
measures below 100 signal pessimistic views from the retail investors.
How the ISEE
correlates with the general stock market
ISEE from 5/1/2013 to
6/7/2013.
Source: Line Graph Outline
from http://www.ise.com. Actual data
compiled by blogger.
Dow Jones Industrial
Average from 5/1/2013 to 6/7/2013.
Source: Line Graph Outline
from Yahoo Financial. Actual data
compiled by blogger.
The ISEE can be used to detect the
short-term trading opportunity. Even if the current ISEE levels are much lower
than those prior to the financial meltdown.
Occasionally, the ISEE shot high.
On 5/21/2013, the Dow Jones
Industrial Average closed at a record high 15,388. The ISEE reading was 142, and touched 186
intraday, a level not seen for quite a while. Next day, the Dow closed down 80
points, and the market had a minor correction until 6/5/2013. The market lost a
total value of about 5% during this time period.
Usage of the ISEE in the stock
market
On the other hand, The Dow Jones
plunged 217 points on 6/5/2013, and ISEE closed at 61, the lowest reading since
5/1/13. The ISEE touched 49 intraday. The next two days, the Dow went up 80 and
207 points, respectively. The market made a
reversal since then. Please be mindful
that the ISEE works as a relative number, not an absolute number. Even if the reading 142 was not high compared
with the readings in 2007-08, it reached a high in recent months.
People might think it is just a coincidence that when the
ISEE is higher than usual, the market goes down, and vice versa. Please take a look at the following chart for
the correlation between ISEE and the S&P 500 movement from a longer term.
The correlation between the
ISEE and the stock market from longer-term view
S&P from 7/11/2011 to
7/31/2013
Source: Line Graph Outline
from Yahoo Financial. Actual data
compiled by blogger.
The above chart lays out the extremes
of ISEE between 7/11/2011 and 7/31/2013. Most of these extremes (highs or lows)
occurred near the top or bottom of cycles.
Generally speaking, when the market was at a climax, the ISEE was also
high. This means retail investors were optimistic about the future movement.
However, it ended up with a pullback or correction. When the market was at the
bottom, the ISEE was low too, usually less than 100.
The low ISEE readings ranged between
41 and 96 in the above chart, which demonstrated the pessimistic view from the
retail investors when the market was at low levels. This chart is showing the clusters of
numbers. Other numbers around these days
revealed the numbers in the neighborhood.
Please note, if the ISEE reaches the
extremes, it usually signals a reversal point in the market or price. It may not be imminent, but it usually takes
place very soon within the next few days.
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.
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