Chapter: 14 Technical Analysis (Technical Indicators)

Section: 1 Sentiment Indicators

Indicators which attempt to gauge individual investor and/or professional attitudes toward the market. Monitoring the degree of optimism or pessimism present is a major tenet of technical analysis. Two examples are the amount of shorting being done and the number of advisory services which are bearish or bullish

1) Odd-lot Trading: Odd-lot traders are almost always small individual investors. An odd lot is a transaction of fewer than 100 shares; 100 shares is one round lot. The odd-lot theory holds that these small investors tend to miss key market turning points, typically buying stock after a bull market has already run its course and selling too late into a bear market. Therefore, the theory suggests that when odd-lot traders are widely buying, you should sell, and vice-versa. You can construct an index of odd-lot trading by computing the ratio of odd-lot purchases to sales. A ratio substantially above 1.0 is bearish because it implies that small traders are net buyers.


2) Confidence Index: A confidence index is computed by using data from the bond market. The presumption is that actions of bond traders reveal trends that will emerge soon on the stock market. The confidence index is the ratio of the average yield on 10 top-rated bonds divided by the average yield on 10 intermediate-grade bonds. The ratio will always be below 100% because higher rated bonds will offer lower promised yields to maturity. When bond traders are optimistic about the economy, however, they might require smaller default premiums on lower rated debt. Hence, the yield spread will be narrow, and the confidence index will approach 100%. Therefore, higher values of the confidence index are bullish signals, and vice versa.


3) Put/Call Ratio: The ratio of outstanding put options to outstanding call options is called put/call ratio. Typically, the put/call ratio hovers around 65%. Because put options do well in falling markets while call options do well in rising markets, deviations of the ratio from historical norms are considered to be a signal of market sentiment and therefore predictive of market movements.


4) Mutual Fund Cash Position: Technical Traders view mutual funds investors as being poor market timers. Specifically, the belief is that mutual fund investors become more bullish after a market advance has already run its course. In this view, investor optimism peaks as the market is nearing its peak. Given the belief that the consensus opinion is incorrect at market turning points, a technical trader will use an indicator of market sentiment to form a contrary trading strategy. The percentage of cash held in mutual fund portfolios is one common measure of sentiment. This percentage is viewed as moving in the opposite direction of the stock market, since funds will tend to hold high cash positions when they are concerned about a falling market and the threat that investors will redeem shares.