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A Simple, Practical Use for ISE Select April 2, 2007
Over the past couple of months, I’ve been using a relatively new service from the ISE exchange called ISE Select.
Unlike other data services from the options exchanges, ISEE Select gives users a proprietary ratio which tells us how predominant call buying is versus put buying. Generally, call buying is seen when traders are optimistic about a stock’s prospects and put buying is a tool for those with a negative outlook.
One of the excellent features of ISEE Select is that you are allowed to quickly and easily export historical data to Excel with the click of a button. That means you can manipulate and test the data in any manner you choose, from plotting it against the base security to designing trading systems around it.
I use this feature all the time, so let’s go over one recent example.
I had noticed that the Nasdaq 100 Trust (QQQQ) seemed to rally when the ISEE value for that security remained high on consecutive days.
Since the ISEE value is a call/put ratio (call/put * 100), persistently high readings show a lot of interest in call buying as opposed to put buying. One would think that this should be a contrary indicator, and high readings should lead to lower prices, but I think we need a different interpretation for hedging instruments like QQQQ.
My theory is that institutions will short QQQQ heavily, but may buy call options to temporarily hedge that short position. So when we see a spike in call volume, hence the ISEE value for QQQQ, it could be a sign that traders are shorting QQQQ itself heavily.
To test this idea, I pulled up the ISEE values for QQQQ and exported the data to Excel, then performed some simple tests. What I found was that when the sentiment index was over 100 for two consecutive days, we tended to see a short-term rally soon follow.
Since the beginning of the data in 2006, we have seen consecutive days with a reading over 100 on 11 different occasions. On 10 of those, QQQQ rallied over the next three sessions, by an average of +1.4% - much greater than a random three-day return during that period of only +0.1%.
Over the next few days following one of these signals, the average maximum drawdown (i.e. loss) of -0.9% was less than half as much as the average maximum gain of +2.1%, giving me more confidence in looking for a short-term rally.
The opposite condition proved useful, too. When the ISEE value for QQQQ was less than 30 for two consecutive days, then the three-day return in QQQQ was only -0.6% and the average drawdown was twice as high as the average gain. Interestingly, the longest stretch of very low readings was right before the equity market plunge in late February, so this data gave a good heads-up that potential trouble was brewing.
This doesn’t just work for QQQQ, either. Using the same parameters on SPY, extremely high values (which for SPY has been 200 or higher), has resulted in a short-term rally each of the five times it’s occurred, leading to an average three-day return of +1.4%.
This is just one way to use a new sentiment tool that is proving to have a good bit of value. By scanning for extremes in ISEE values among sectors or your own watchlists, you should be able to find more than enough trading ideas to pay for the nominal subscription charge.
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