Trader’s Narrative

Over the next few months and even till the end of the year, I’d be willing to “forecast” that we will close higher, but for the next few days and weeks, the market may be heading into some kind of a short term top or choppy trading.

I was looking over some different indicators to take the pulse of the market when I noticed that according to the ISE Sentiment there are too many calls being bought compared to puts right now.

In fact, the ratio is at levels which have in the past marked market tops. As you may recall from the last time I talked about the ISEE data, it only measures opening long customer transactions on International Securities Exchange. Which makes the data very useful, especially considering the growing volume of options traded on the ISE.

Take a look at the graph below which compares the S&P 500 to the ISEE sentiment data. As you’ll notice, when the 10 day moving average rises too much (too many calls bought to open, compared to puts) the market has a hard time powering ahead. It either swoons or enters into a sideways range.

There’s no magic to the number 10 by the way. Any short term moving average would smooth out the data and show you the same thing (more or less).

On Friday, the market was jolted down quite harshly. Although the move printed a wide range candle on index charts, it did not result in any sort of oversold readings. So the market certainly has room to the downside. And you have to remember that a bull market never makes it easy. It bucks at every chance to try and throw you off.

If we do see some general market weakness though, I’d really be wary of the soft sectors like the financials. The banks and brokers will most probably get the brunt of any serious selling since they are already very weak relative to the market.

Click to Enlarge Graph:

The International Securities Exchange is a relative newcomer to the options market. It offers an all electronic market and has used the leverage of technology to alter the landscape of options trading. The ISE offers one of the most most level playing fields for retail traders. With a growing amount of trading volume the ISE has become an alternative source of options sentiment data.

Most are familiar with the CBOE put/call ratio. But the ISE’s sentiment index is a little bit different. Here’s their own explanation:

“The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.”

Instead of dividing puts by calls and showing the results as a number, like, say 1.0045, the ISEE shows the number of calls traded for every 100 puts. So when you have a number less than 100, it means that more traders have opened long put options than long call options.

Because the ISEE excludes market makers, and because it only shows opening positions, it presents a fairly accurate measure of sentiment.

During the last intermediate market bottom, there were 3 days where we saw very pessimistic readings on the ISEE. On March 8th 2007, there were 58 calls traded for 100 puts. And on the day before and day after, the ISEE also showed very low readings:

In fact, the reading we saw in March was the lowest in the history of the ISEE (see table below). By contrast, last week, we saw a fairly low reading of 74. But it wasn’t even close to the previous market low. Here are the lowest 20 readings of the ISEE. Also, I’ve included the top 10 daily decreases and increases in daily ISEE readings: