Sentiment also can give a bigger view of the market. One sentiment gauge that provides a long-term view of the market is the short interest for the NYSE. First, understand that short selling allows a trader or speculator to profit when the market or a particular stock is declining. To short a stock,
a trader sells a security that he or she does not own. Rather, the short seller "borrows" a security and sells it, and then hopes to buy it back at a lower price later on, thus earning a profit when the borrowed security is returned. However, the security can also go up in price, and the trader must buy it back (covering the short position) at a higher price than what it was sold for, resulting in a loss.
Short interest reflects the total number of shares of a stock that have been sold short but not yet covered. The NYSE reports the total short interest for each stock once per month around the middle of the month. A large increase or decrease in short interest can be a good indicator of sentiment. A high short interest reading means that a large number of people believe that current prices are too high, and that the market or a particular security should decline. If a stock has relatively few shorts, then the majority of people believe that the market or a particular security should rally.
The short interest ratio is the total number of shares sold short (short interest) divided by average daily volume. Given an issue 's average daily volume, it would take X number of days to cover the short position in that particular issue. The higher the ratio, the longer it would take to buy back the borrowed shares to cover a short position. That short covering, in addition to the normal buying of the issue, indicates just how bullish the issue potentially would become.
The exchanges also have short interest indicators that are simply the sum of all the individual short stocks traded at that exchange. The traditional way to calculate the short interest ratio of the NYSE is to take the short interest on all the stocks in that exchange and divide it by the average daily volume on the NYSE over the past month. A buildup of short interest is potentially bullish for the market because the shorts will eventually cover (providing buying power), which drives prices higher. Therefore, high short interest ratios tend to be bullish. Conversely, low short interest ratios mean that investors are basically bullish on the market. That, in turn, takes away the potential buying power of short covering, which tends to have a bearish effect.
Figure 7.15 shows the short interest ratio for the NYSE going back to 1990. The chart, provided by www.SentimentTrader.com, presents the data on a detrended basis, which is a means of looking at the data in such a way as to cancel out whatever long-term trend may be in place. In the case of short interest, increased hedging activity has skewed this indicator. The mathematical manipulation of volume and short interest (detrended) create an accurate presentation of what the chart is supposed to display.
Significant tops can occur when the Short Interest Ratio—NYSE (detrended) reaches near the —0.2 range, as happened at the 2000 top, represented by the largest arrow in Figure 7.15 - Notice that from early 2006 to mid-2007, short interest increased from the —0.1 range to near 0.03, which at the time was a bullish, longer-term sign. This indicated that something similar may happen here as occurred from 1997 to 2000, when the market rallied significantly and squeezed off the shorts, taking the short interest ratio (detrended) ratio from 0.2 to — 0.2.
As of this writing in mid- 2007, the short interest ratio on the NYSE (detrended) gave a longer-term bullish signal and suggested the rally that started from the 2002 low still had much farther to go. Notice that the short interest ratio reading in mid-2007 was higher than the reading at the 2002 low. This condition suggested that because of the heavier short position in the market in mid- 2007 compared to the 2002 bottom, the investing public was more bearish in mid-2007 than at the 2002 low.
When and if this ratio reaches the —0.2 range that will be the time a significant top may form.
Keep in mind that the Short Interest Ratio—NYSE (detrended) is only one indicator that was giving a longer-term bullish sign as of this writing. However, not all indicators work all the time, and it 's fair to note that the short interest ratio could fail—just like any number of indicators that have failed in the past.
SUMMING IT UP: THE CONSENSUS OF INDICATORS
The key to successfully trading is to find as many indicators to confirm or deny the trend you are trading. When most of the indicators start to deny the trend, then it is time to pack up and leave that trend. There is not a "Holy Grail" indicator out there (at least I haven't found it) providing profitable trades every time. Rather, traders must use a consensus of indicators to light their way to financial trading success. In the previous chapters, I have outlined the indicators and methods that have worked for me, allowing me to achieve trading success. By taking time to study and review these chapters, traders should benefit from their efforts.
In the next chapter, we will look at how to put it all together, keeping it simple with a common-sense approach and covering the important topics of each chapter in sequential order. Your trading journey is nearly complete, and my hope is to give you a road map leading to your trading success.
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