How to Profit from the Stock Market by Applying ISE Sentiment Index

The International Securities Exchange launched the ISE Sentiment Index (ISEE) in 2002.  This index is to gauge retail investors’ sentiment in the market by measuring the number of opening call options vs. opening put options, which are placed orders on the International Stock Exchange platform. 

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

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.

The leading publications often referred ISEE as a helpful trading means due to its inventive arithmetic technique.  It enables investors and traders, even investment professionals, to examine with this exclusive call/put ratio, how retail investors view the general stock market.  Therefore investors can make trading decisions based on the sentiment derived from ISEE.

Some studies show that a gathering of consecutive highs or lows in ISEE reading indicates that the market might move in the opposite direction of what the retail investors are betting on. This characteristic identifies the ISEE as a contrarian indicator. 

As a contrary indicator, we are looking for rising prices when ISEE reading is low-hanging, and retail investors show pessimism about the stocks or market.  Conversely, when the ISEE index poises at a high level, the market prices are going to drop. 

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. 

Most often, when everyone is very bullish and wants to buy stocks, most investors have already been in the stock market.  The buyers exhaust or extinguish their purchasing power.  The demand has been met and it becomes remarkably difficult for stock prices to continue to gain as investors expect.  This case may spark a sudden sell-off. Meanwhile, the stop-loss orders might trigger and accelerate the downward process. 

The opposite situation might present after dismay sell-off.  If everyone jumps out of the window and disposes shares about the same time period, then the market becomes gradually stable.  The market or stock price starts to advance when the bargain hunters purchase shares. The surge in price is going to prompt a short-covering rally. Moreover, regretful investors buy back shares which they disposed, and fuel the rally even more vigorously!  As a matter of fact, when bountiful investors stretch out to bet on the downside of the market, eventually the stock price might be close to oversold and poised for a nice rebound. 

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!

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