Do not fall off the See-Saw

When they're up....you're down. When they're down,... you're up. It's the "contrarian see-saw". Most everybody agrees that market sentiment can be a very important component to doing the almost impossible-timing the market. The Japanese rice traders knew that over 400 years ago when they developed the popular candlestick system for identifying changes in sentiment. Some of the modern day versions used for gauging sentiment are: Relative Strength Index (RSI), Volatility Index (VIX), and Put/Call Ratio. The basic concept is that fear (oversold) and greed (overbought) help the trader pick trades, strategies, and entry and exit points. When there is an excess of fear, the trader may want to be buying. When there is an excess of greed, it's probably time to sell. But like all indicators, they must be considered in context.

If a stock is imploding, no doubt the prices will drop and show an obvious negative sentiment. But does this mean we should buy when an index shows an oversold condition? Also, a stock on the rise might show an overbought condition but does that mean it will come screaming down when the index reaches new highs? Being a contrarian can be hazardous if sentiment indicators are taken on their own. Trying to read order out of chaos is too complicated for just one, two, or more indicators.

However, there is little doubt that sentiment is a valuable factor. Considering market sentiment equivocates with trying to time the market; usually considered a taboo. But stock traders of all ilks take timing the market as key to making money (buy low and sell high...but when is low really low or high really high?) Stock options and futures traders are notorious time bandits. To them, timing and direction are the two prime mandates: which direction will the price move and when will the movement take place? If a trader is good at divining these factors, they can make a very good living. It's like a nut-shell game; it looks so easy but when the expected outcome doesn't happen, the world temporarily comes apart. Reality defiled. That's why being a trader can become an emotional roller coaster. But if you were standing on a street corner with thousands of others there to give you advice, would you listen to them? If the majority told you not to choose the center shell, would you heed their advice? My point being is that sentiment is consensus and normally consensus is better than individual opinion. Why is it that sentiment indicators are set up for traders to choose an opinion contrary to the consensus?

A recent study presented by Market Harmonics (http://www.market-harmonics.com/) demonstrated an interesting fact. The article "Put/Call Ratio vs. Volatility Indices" showed that the Put/Call ratio is a much more sensitive indicator of "real-time" sentiment and that The VIX (S&P Volatility index) and VXN (Nasdaq Volatility index) are more indicative of sentiment trends. The logic is that Stock option traders are more deliberate when choosing the price they will pay to buy future per-formance, whereas Put/Call ratio is more a reflection of a reaction to the market. The implication of the article is it is best to use both indicators to see if sentiment is just a short-term emotional reaction as indicated by the put/call ratio or a more sustained trend as indicated by the VIX and VXN.

Another way to moderate a tendency to jump at overbought or oversold situations is to wait for a retracement to test the sentiment. Many times-particularly when using the RSI-an indicator will make a correction just out of exhaustion and then retrace back to the oversold or overbought condition.

Bottom-line, when attempting to time the market, always have multiple supporting indicators and realize that taking a contrary position can be risky if there isn't a very high probability of reversing direction.