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Visualizing Market Sentiment Relationships

Before delving into the applications of the DSI as a filter, let's first examВэine the ideal and actual relationships between DSI, price, tops, and botВэtoms.

Figure 19-2 shows the ideal relationship between market sentiment and trend. As you can see, market sentiment tends to increase with an up trend and decrease with a down trend. In fact, market sentiment very closely mimics trend in virtually every market. There are some sigВэnificant instances, however, in which daily sentiment and trend differ markedly.

These are, in particular, tops and bottoms. Figure 19-3 shows the ideal relationship between DSI, market tops, and market bottoms. Compare both the ideal trend relationship from Figure 19-3 as well as the top and bottom relationship from Figure 19-3 with the actual charts shown in Figure 19-4 through 19-6. These charts are not exceptions. The fact is that a significant number of important tops occur when the DSI is at 90 percent or higher and that a significant number of bottoms occur when the DSI is at 15 percent or lower. This is an important market relationВэship which can be taken advantage of by the day trader. But how?

The Importance of Market Sentiment

As I've already noted, one of my favorite methods of finding potentially profitable day trades is to use daily market sentiment as a filter. Typically, when daily market sentiment is very high, markets tend to top, and when daily market sentiment is very low, i.e., bearish, markets tend to bottom. In many cases, the highs and lows in market sentiment virtually all other markets are like strangers to S&P futures. Why does this happen? Although I'm not entirely sure, I do have my theories. Perhaps the most cogent reason is that the S&P futures market is a hybrid, representing both stocks and futures. The market is monitored closely by computers and money managers for imbalances. Furthermore, it is used heavily as a hedging vehicle by stock fund manВэagers. Although it is a speculative market, it is affected by a host of variВэables which do not affect most other markets.

Yet there is one variable which seems to work better in S&P futures than in any other marketтАФand that's daily market sentiment. Because S&P is such a liquid market (most of the time), because it is followed by stock and futures traders, because it is heavily traded by professionals from all sectors of the financial arena, because it is the quintessential speculators market, and because it has a high dollar value per tick, it is a market which is more sensitive to trader emotion than any other futures market in existence today. And this is all very comforting to those of us who enjoy having reliable indicators to assist us in our trading decisions.

Вц DSI with gap signals of both types. One of my favorite applications of the market sentiment as assessed by the DSI is with gap trades. It is not uncommon for the best gap trades to occur in close proximity to extreme sentiment readings. As you can easily imagine, your best odds for buy gap trades of both types is when sentiment is at or about 15 percent or lower. Your best sell gap trades will occur when sentiВэment is at about 90 percent or higher.

Вц MA channel and DSI are also an outstanding combination. When DSI is excessively high, you can expect an MAC sell signal to develop on the intraday charts. In such cases you can feel relatively secure selling against the MAH as well as the MAL and, of course, the midpoint of the channel. When DSI is excessively low you can expect an MAC buy signal to develop on the intraday charts. In such cases you can feel relatively secure buying against the MAH as well as the MAL and, of course, the midpoint of the channel.

Вц Stochastic pop signals can also be filtered using DSI. I suggest caution if you get an SP buy signal when sentiment is about 90 percent or highВэer or a sell SP sell signal when DSI is about 15 percent or lower. SP signals seems to work best when DSI has not reached an extreme level on either side.

Вц Critical time of day (CTOD) signals also appear to be related to DSI. I do not have any hard evidence to support this conjecture due to the limВэited number of cases. It appears that when DSI is at a high extreme, CTOD sell signals will be more reliable. When DSI is at a low extreme,

CTOD buy signals tend to work better. (See Chapter 20 for discussion of CTOD methods.) Вц Oscillator signals, as discussed in a previous chapter, can also be filtered with DSI. When DSI is too high, oscillator buy signals are apt to be unreliable whereas oscillator sell signals are more likely to work well for larger moves. Conversely, when DSI is too low, you should be careful about taking sell signals, since oscillator buy signals tend to be more accurate and they tend to produce larger moves.

In the final analysis, market sentiment can be used as an excellent filВэter for the many different day-trading methods and systems I've disВэcussed in this book. Daily market sentiment is subject to such wide swings because it is based on trader response, which is, in turn, based on trader perception of market events. Trader perception is mediated by emotion. Hence, DSI is an excellent indicator of emotion. Since many large intraday price moves are based on emotion, DSI is an excellent method for determining markets which are in an emotional state suffiВэciently conducive to reliable intraday moves. That's why I urge all day traders to be aware of and to use daily market sentiment.