The International Securities Exchange (http://www.ise.com) equity only call/put ratio investor sentiment index (ISEE) is more refined than traditional put/call ratios because it only uses opening long customer transactions to calculate bullish/bearish market sentiment. Opening long transactions, i.e. where the investor “buys-to-open” a call or put leg, are thought to best represent market sentiment because investors often buy call and put options to express their actual market view of a particular stock. Short orders (i.e. sell-to-open) are excluded since myriad options strategies could be involved and thus are not representative of true investor sentiment. Furthermore, trades from market makers and institutional broker/dealers are excluded since their trades are usually part of more complex trades, such as spreads, butterflies, diagonals…etc. so these trades can “muddy the waters”. As a result, the ISEE calculation method allows for a more accurate measure of true investor sentiment than traditional put/call ratios. Moreover, the ISEE focuses on equities only and does not include options opened on ETFs and indexes, because many of the trades on ETFs and Indexes are used as hedging instruments, so they reflect less accurately on true investor sentiment.
The ISEE value is calculated by dividing the number of equity only long call “buy-to-open” transactions divided by the number of equity only long put “buy-to-open” transactions, and then multiplied by 100. The calculation is then written as (long calls/long puts) * 100. If ISEE is > 100, investors are buying more calls than puts and this can be interpreted as bullish investor sentiment. If ISEE is < 100, investors are buying more puts than calls and this can be interpreted is bearish investor sentiment. To further refine the number we apply a 10 day simple moving average (SMA) to the ISEE, which filters out the daily fluctuations. Because retail investors tend to buy more calls than puts, the equity-only ISEE number tends to be at “equilibrium” near 130. Looking at an example, if the equity-only ISEE value is 163, this means that for every 163 long calls that were purchased, 100 long puts were purchased, and this would represent bullish investor sentiment. On the other hand, if the equity-only number were 105, this would represent bearish sentiment among retail investors, since equilibrium is closer to 130.
Below is an example of the traditional use of put/call ratios as a contrarian trigger to go against the herd when extremes of apparent imbalance develop between the trading volume of calls versus puts. The logic states that excessive volume in either calls or puts highlights extreme levels of bullish or bearish conviction. Excessive bullishness, for example, often foreshadows an overbought market condition. When too few buyers are finally left on the sidelines then long liquidation or short selling will force the market to move lower.
Below is the S&P 500 index (SPX) price chart for 2008 through Feb 27, 2009 and its corresponding 10 day simple moving average (SMA) of the ISE equity-only call/put sentiment indicator (ISEE). For this time period 140 represents equilibrium (the mean), values > 165 represent extreme bullishness, and values < 115 represent extreme bearishness. We can see that the ISEE indicator hit extreme bullishness in early January 2008 giving us a warning of upcoming bearish price action in the SPX. Additionally, the ISEE hit extreme bullishness again in early June 2008, foreshadowing the immediate sell-off in June/July. At this point the SPX collapsed in Oct 2008.
Below is the S&P 500 index (SPX) price chart for 2007 and its corresponding 10 day simple moving average (SMA) of the ISE equity-only call/put sentiment indicator. For this time period 190 represents equilibrium (the mean), values > 210 represent extreme bullishness, and values < 160 represent extreme bearishness. We can see that we hit extreme bullishness in early July 2007 giving us a hint of some bearish price action in the SPX; additionally, the ISEE hit extreme bullishness again in early Oct 2007, foreshadowing the pull-back in Nov 2007.
Below is the S&P 500 index (SPX) price chart for 2006, and its corresponding 10 day simple moving average (SMA) of the ISEE equity-only call/put sentiment indicator (ISEE). For this time period 185 represents equilibrium (the mean), values > 210 represent extreme bullishness, and values < 160 represent extreme bearishness. We can see that we hit extreme bullishness in early January ’06 but this incorrectly predicted any type of sell-off. The ISEE hit extreme bullishness again in early May ’06 and this one correctly predicted the May/June sell-off. The ISEE showed extreme bearishness in Mid Aug ’06 and this correctly predicted the rally that ensued Aug through Dec ’06.