Wednesday, November 15, 2006

Trader Short-Term Sentiment Matters

Some of my favorite trading patterns look at the relationship between price change and sentiment to find a short-term trading edge. My preferred sentiment measure for intraday trading is the NYSE TICK. I use an adjusted version of the TICK, which simply subtracts the 100-day average reading from the raw figure, creating a zero mean.

Let's see what that short-term sentiment tells us:

Since 2004 in the S&P 500 Index (SPY), there has been a bullish drift. SPY has averaged a gain of .06% on a two-day basis, with 381 periods up and 337 down.

Now let's divide those occasions into periods when the day's average TICK reading was positive (bullish sentiment) vs. negative (bearish sentiment).

When the two-day Adjusted TICK was positive, the next two days in SPY average a loss of -.02% (187 up, 186 down). There's no bullish drift at all.

When the two-day Adjusted TICK has been negative, the next two days in SPY average a gain of .16% (194 up, 151 down).

What that tells us is that the bullish drift in SPY has been a reversal effect, in which markets move opposite to short-term trader sentiment. Returns are subnormal following bullishness and outperform following bearishness.

Combine that principle with your favorite intraday setups and you can derive a nice little edge, as those who sold cover their shorts and those who bought puke out their longs. Understanding the dynamics of mean reversion is key to trading the current equity index market.