Market sentiment can be measured in many ways. These include Investor's Intelligence surveys, the Daily Sentiment Index (NYSEARCA:DSI), as well as readily-available VIX and Put/Call ratio indicators.
Baseline Analytics TrendFlex uses VIX and Put/Call ratios as an indicator to assess the risk of the current trend changing.
For example, see the chart below. The S&P500 is plotted on the main chart with VIX (pink line) behind it, and the Put/Call ratio below. Each indicator is compared to its 34-day exponential moving average.
You will note the ovals drawn at various points on the VIX chart as well as circles drawn on the Put/Call ratio chart. These indicate extreme points vs. the indicator's 34-day exponential moving average. VIX and Put/Call indicators and their "gap" from the moving average are treated as contrary indicators. In calculating part of its TrendFlex Score, Baseline Analytics treats an extreme high in VIX or Put/Call, considered "extreme fear," as a contrary indicator. This signals a potential bullish trend change. Note the extreme points marked at the start of June 2012. That point effectively signaled a shift in the S&P500 from a downtrend to an uptrend.
Today, VIX remains over 20% below its 50-day exponential moving average and 18% below its 34-day moving average. See the chart below:
Please note that Friday was options expiration day, so that may have skewed the final price. But in the past, such extremes versus these moving averages have been useful technical indicators to suggest caution with the current trend. With VIX being low and suggesting complacency, investors are encouraged to protect long positions with stops, hedge with options or index shorts, and not to wholeheartedly embrace the uptrend by adding aggressively to long positions, afraid to miss the rally.
Although this signal is not 100% effective on its own, traders and investors are encouraged to use this tool alongside other technical indicators to assess the risk of change in the current trend. Click here to learn more about Baseline Analytics TrendFlex indicators and our TrendFlex Score designed to measure the risk of a trend change.