Measuring Emotion and Urgency

• Posted by Derek
• on November 19th, 2010

The goal of converting sentiment into profits has eluded most, if not all, self-dubbed contrarians.  Of course we all “know” that if everyone is bullish, there is no one left to buy…if everyone is bearish, there is no one left to sell.  But dissect those sentences, and you find far more questions than answers.  How do we define “know”?  What % equates to “everyone”?  How do we measure whether someone is bullish or bearish?  And even if they are, is there not a chance they will cave to performance pressure if their opinion was early?

As much as I love the idea of designing a magical sentiment indicator, I just haven’t found one.  Each has its own quirks:

1) Put/Call Ratio: probably the best, it at least measures what people do rather than what they think.  ISEE has improved on CBOE methods by measuring opening long transactions rather than all.  But still, crowds can persist in being “wrong”, and the introduction of inverse ETFs has diluted the exclusivity of index puts as a hedge.

2) VIX: as Adam Warner says, “a derivative of a statistic”…it does have a decent record of reversing extremes as shown by Larry Connors.  Keep in mind, though, that convergence strategies work until they don’t.

3) Breadth Surge/Plunge: across the board bursts of strength or weakness are indicative of the emotion seen at inflection points.  However, given the influence of ETFs and reduction in commission costs we’ve seen an explosion in instances.  This doesn’t make them obsolete, but clearly dilutes the message.

4) Bull/Bear Polls: historically pretty good at finding bad times to short, not good times to sell.  Timeframe is vague, and institutions running long-only books are going to buy and/or hold stocks until they’re forced to meet redemptions.

We are seeing more interest in using Google and Twitter trends to measure what has grabbed the attention of the public.  At the end of the day, however, using sentiment comes down to the decision maker.  Without a way to interpret the data and apply it in the right timeframe, it becomes one more piece of noise to cloud our planning and execution.

Why not use good old fashioned volume and range to identify emotion?  Many have tossed aside volume because it tests so poorly.  But that’s because the largest volume spikes occur at breakouts and exhaustions…totally different structures that require one data set for “early” volume and one for “late”.

At least abnormal volume and/or range occur frequently enough that we can live through a larger sample size in developing our ability to interpret emotional extremes.  Not only that, but instead of focusing on a few indices, we can apply our findings to the entire universe of stocks in order to discover more and better opportunities.

It’s as simple as this…average volume and average range imply the (rational) continuation of the recent phase.  Unusual volume or unusual range, be they larger or smaller than normal, imply the presence of emotion.  Large volume means new information, someone is caught off guard and feels the need to adjust.  Large range means the prevailing range wasn’t wide enough to facilitate normal trading…this can mean new and important information, or that someone felt panicked and rushed to act beyond the typical range.  The first instance should have persistence, the second will be fleeting.  Narrow range might mean anxiety…this builds energy for an outsized move once marginal buyers and/or sellers decide to act.

Even though my time frame is weeks to months, I use 7 day volume and range as my “marker”.  There’s no significance to that number, but applying the methods of Crabel and Cooper and Connors and Raschke and Dalton over the years has led me to consider 5-10 days as the yardstick against which I can find significance in volume and range.  I find index volume useless, but range carries good information…both have usefulness for individual stocks, though.

Don’t discount the numbers, look beyond them.  Why was the volume so far from average?  What does this unusual range imply?  Large numbers often imply change in phase…flat to up, up to flat, flat to down, or down to flat.  If you can identify the prevailing phase, this burst of emotion may be the guide you need to tell you that the phase is changing.

A few stocks that made 20+ day highs or lows this week, AND showed unusual activity in doing so, include BA, HGSI, CSCO, FO, A, JOYG, SHLD, FSLR, DKS, HD, URBN, MAT, JCG, HON, NTAP, RF, FL, ROST, GME, LTD, WFT, CAH, CVC, DLTR, NTES, HUM, SJM.  I purposely didn’t characterize these as bullish or bearish…these are simply names where the presence of “other timeframe” participants was obvious by larger activity at new price levels.  This is good hunting ground to BEGIN research, knowing that we’ve identified situations where emotion(fade) or new information(follow) appeared.  Leaning on recent activity levels to position ourselves with the elephants is a win-win..why guess where activity might arrive?

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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