Gauging the Sentiment of Traders

07/07/2011 7:30 am EST

Focus: STRATEGIES

Jackie Ann Patterson

Author, Truth About ETF Rotation

Indicators like the MACD and the put/call ratio can give helpful insights about traders' positioning—including those who are on the other side of your trade, says Jackie Ann Patterson.

Our guest today is Jackie Ann Patterson and we’re talking about how you access the sentiment or feelings of traders. Maybe even the traders on the other side of your trades.

So, Jackie, how do I do that? How do I know what the trader on the other side of my trade is thinking?

Well, I think there’s a couple of ways to gauge what they’re thinking and how they’re feeling.

One is looking at the sentiments of traders. Looking at, for example, the put/call ratio, and that tends to be contrarian when people are ignoring puts and they’re focusing on the calls.

That can be a very bullish situation, but when it becomes overbullish, then it’s sometimes due for a change.
One way to get an idea of whether that time is coming is to look for divergences in the market and various indicators.

So, when you talk about a divergence, it means these two different indicators saying different things?

Yes, it can be something like that, or it can be more subtle, that the price says one thing and the indicator says another.

For example, if price goes up and makes a new high, but an indicator falls short and does not make a new high, that’s a classic divergence.

I know a lot of people talk about MACD and if it starts to turn over and yet the price keeps going higher, is that a good example?

That is a very good example with the moving average convergence divergence (MACD). I think that’s where I’ve found a lot of divergences and been able to get inside into the market that way.

NEXT: The Most Important Indicator Divergences to Watch

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Alright, so I know the question then becomes which ones are best? Which is the most important divergence to look at?

Yeah, well I think that there are some that have more longer-ranging influence and some that are shorter term, so an indicator like the MACD is fairly complicated, and it’s got the lines and the histogram and a divergence on the lines may be something that’s more of a weighty signal that may take time for the actual change to develop, and then the new trend may carry on longer.

Whereas a MACD histogram is much more of an oscillating signal and changes value more often. So a divergence on that might happen more immediately, or you might see an effect of it in the price more immediately, but it may not last quite as long.

By doing this, we’re almost trying to get in front of it before it happens, so should I leg into this and only put a partial size on to see if it actually happens? What do you suggest there?

Yeah, I think being cautious is definitely a good idea. And absolutely use a stop in case it goes the other way, because when it goes the other way, it can be going very strongly in resuming the trend.

As far as legging in goes, yeah, that can be a good idea to start out small and then as you see the situation change and a new trend emerge, then that’s a good time to get in on it.

How about commitment of traders? I hear a lot about that as a way to kind of get a view of the market. Do you use that?

I used that in the past and then I kind of drifted away from it in favor of the put/call ratio and in favor of looking at divergences.

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