Consensus Indicators and Trading Psychology

Because it is unquantifiable and generally misunderstood by most traders and investors, psychology is the often overlooked intangible aspect of trading. Unlike the precise mathematical formulas used in technical analysis, we cannot easily reduce human behavior to a mathematical equation that can be plotted on a graph as a trend line or as a series of variables that we can examine in detail throughout history. 

That said, much current research in the social sciences is attempting to bring psychology more in line with mathematics for the precision that it gives to experimental methods. Mathematical methods are applied to behavioral science for the purpose of observing and comparing human behavior according to a set of strict numerical criteria - the only stable benchmarks that allow comparison of behavior from person to person and from time to time.

In relation to trading and investing, we can consider two very different approaches to psychology in the markets: individual psychology and group psychology. Individual psychology obviously looks only at the behaviors of the single individual trader. Attempting to draw conclusions based on the actions of the herd, mass psychology (or group psychology or crowd behavior) examines how behavior of all investors exerts an effect on a stock price (or option price or currency value).

The foundations of how crowd behavior relates to investing are rooted in the distant history, all the way back to the famous Dutch tulip mania of investing folklore. Interestingly, the behavior of crowds is a paradoxical indicator when applied to stock markets. When most investors are in consensus and are driving the market in a particular direction, one naturally thinks that the consensus will continue ad infinitum and that the best trading decision is to follow the crowd.

But history has proven exactly the opposite. When driven strongly by consensus, crowd behavior is actually a contrary indicator. When the consensus of the majority of investors or traders is strongest, the individual trader should do exactly the opposite of what the crowd is doing. The astute trader profits by doing quite the opposite of what, at first glance, it seems to be logical. When the market is strongly bullish, the astute trader is ready to short the market. When the market is bearish, he or she gets ready to buy.

But you would not be faulted if you were to question this strategy of trading. How do I know that the contrary trade is not going to be exactly the wrong action? Mass psychology may continue to drive the trend for a longer period of time. And how can I expect to identify that exact magic moment, the single day or week, when the consensus indicator is strongest, the absolute best time that I should make my contrary move?

To answer these questions, traders must realize that a consensus indicator is not meant to be an absolutely precise indicator. Market consensus should be used as a clue that a trading opportunity is afoot. It indicates that it is a good time to apply more detailed analyzes to particular stocks or currencies. It is important to find out if the trading opportunity is supported by technical analysis or momentum indicators.

But the second question that I raised is the more interesting one. How do I identify when the consensus is strongest? Several tools are used to help investors roughly identify the consensus of the market. Most of these tools tabulate a numerical consensus indicator on the basis of advisory opinions, signals from the press or signals from advertisers. 

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Advisory Opinion 
The advisors of which I speak are ubiquitous newsletter writers who service their subscribers week-by-week or month-by-month by giving opinions on the future direction of markets or individual stocks. Sources such as Investor's Intelligence and Market Vane poll these newsletters to track the bullishness or bearishness of the market. Even if the individual letter writers are blindly regurgitating whatever they hear in the media, these polling services, because they have developed special numerical figures to analyze these newsletters, can assign either a bullish or bearish value to each of the opinion letters. These services then tabulate the overall bullishness or bearishness of their entire universe of advisors. When this numerical value crosses a certain threshold, either a buy or a sell signal is issued. The signal is issued contrary to the balance of advisory opinion.

The Press
By their very nature, financial journalists are fence sitters. Financial newspapers and magazines do not ever want to be wrong in their opinions, so they present reportage within their pages that is as innocuous and non-committal as is humanly possible. Journalists' fence sitting only disappears at the end of a long trend, when the balance of opinion amongst analysts, investors and the press has reached a strong consensus.

At this time, the press will jump firmly onto one side of the fence or the other, presenting strong opinions concerning the state of the market and its likely short-term direction. When journalists have jumped to one particular side of the fence, astute traders climb over the fence and position themselves on exactly the opposite side. Standing huddled as a group, the journalists look at the lone trader through the rungs of the fence with smug expressions on their faces. In a very short period of time, however, the trader will be the only one with reason to exhibit any smugness once the markets change direction to his or her advantage and in exactly the opposite direction to the predictions of journalists.

Take a look at a major business newspaper one day and see how many ads you can find for certain individual investment opportunities, such as real estate, commodities or certain types of equities. Chances are you will find several ads touting the investment potential of one particular investment or another. When you notice, for example, a large number of ads for the potential for appreciation in the price of gold, the price of gold is likely to be near its top. When the advertisers get together to scream 'buy', the astute trader walks very quickly to his or her terminal in order to hit the sell button.

Trading contrary to opinion is deadly effective because of the often-misunderstood axiom that much of living is based on the power of paradox. At the surface, many aspects of life and of investing, like the power of consensus trends, appear to be true and straightforward. But as we have seen, the herd is almost always wrong or at least late in jumping on the bandwagon. As we see time and again, both in the markets and in life in general, when the herd finally jumps aboard a trend, that trend has very nearly run its course.

The individual who is able to recognize the inherent paradox in crowd behavior is best able to capitalize on the inevitability of contradictory opportunities.

Consensus indicators may cause an astute trader to do exactly the opposite of what, at first glance, the market is telling him or her to do. The best sources for getting a sense of consensus on the markets are investment newsletters, the press and newspaper and television advertisements.

Despite their usefulness, however, consensus indicators aren't the only gauge of market psychology. There are many other groups of players with large stakes in the markets; these are professional investors and traders with much larger financial stakes than the ubiquitous (and noisy) market commentators and advisors. By virtue of the size of their financial commitments, these professionals are often considered better able to gauge the prospects for certain investment vehicles.

The activities of professional market players are collectively referred to as commitment indicators, whereby a group is measured on the basis of its actual financial commitments to particular investment vehicles. Commitment indicators are applicable to most trading instruments, including those found in equity markets and commodity exchanges.

There are several agencies that attempt to categorize the wide range of investment and trading professionals and measure their success (or lack thereof) against similar players. Let's take a look at some examples of commitment indicators applicable to commodity traders as well as those used to measure corporate insiders trading their companies' stocks.

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Commodity Traders
The Commodity Futures Trading Commission (CFTC) requires that big speculators (those who are long or short at least 100 contracts of corn or 300 contracts of the S&P 500 futures) report their positions on a daily basis. The CFTC compiles these reports into the weekly Commitment of Traders Report.

The Commitment of Traders Report divides all commodities traders into three groups: commercial traders, small speculators, and large speculators. Commercial traders are also knows as hedgers, as they are actually engaged in business activities where hedging on the futures or options markets is a normal course of their business operations. The business activities of hedgers can be enormously broad: hedgers may be stock traders who trade S&P 500 futures to hedge their stock portfolios or they may be large farming companies that hedge their summer's harvest with wheat futures.

Regardless of their trading activities, commercial traders are one of the few groups on any exchange that can legally trade on inside information. If our wheat farmer friend was the only one who knew that the summer's weather would wreak havoc on the nation's wheat crop (as if weather forecasts can be considered inside information!), he could legally insure the price of his anticipated crop by purchasing futures against the summer price of wheat.

The individual trader who is not part of an exclusive group that might have inside information on his or her commodity of choice can still benefit from the knowledge of the insiders by examining the open interest records of commercial traders. If the open interest (commitments) indicates a majority of long positions, then the individual trader may construe the open interest commitments to be the best indicator for writing a long contract for that particular commodity.

This is a very significant point because commercial traders (hedgers) are one of the few groups on any stock, option, or commodity market to demonstrate significant trading success on an ongoing basis. The Commitment of Traders Report is one publicly available document that is worth its weight in gold for the individual commodities trader.

But the story does not end at the long and short positions. The trader still does not know whether the long or short position is a hedge against ownership of a physical commodity. So the trader must then look at a newsletter called the Bullish Review, which measures current commitments against their historical norms. Only an extreme bullish reading on the Bullish Review would indicate uncommon bullishness of the commodity commitments; likewise, only an extreme bearish reading would indicate uncommon bearishness.

The second and third groups that are mentioned in the Commitment of Traders Report deserve a brief mention here, as well. Large speculators are considered noncommercial traders by the report because they meet the minimum number of contracts to be included on the report, but their futures contracts are not explicitly used for hedging in their business activities. Most of the large traders at present are commodity funds, which generally do not provide useful trading information because of their poor long-term performance on the commodity markets. The small speculators are not considered reportable positions because they do not meet the minimum number of contracts for the report. Small speculators compose the balance of the masses, and their activities should probably not be considered a source of useful information.

Equity Traders
The equity markets' equivalent to the Commitment of Traders Report is the Securities and Exchange Commission’s (SEC) Insider Trading Report. You will immediately notice the similarity between the commercial trader of the futures market and the corporate insider of the stock market - the corporate insider is most likely to trade based on inside information of his or her company's business activities or his sense of his company's future prospects. Note that for the purposes of this discussion, inside information is not being referred to in the legal sense, but is simply referring to a corporate insider's general feeling over the future prospects of his or her company and the influence of these feelings on his or her trading decisions for the company's stock.

Insider buying and selling is tabulated by the SEC and released to the public once each month. While individual corporate insiders, when considered in aggregate, are notoriously poor market timers, more than three insiders buying or selling may just indicate the imminence of positive or negative news (a gray area in legal terms). Insiders have been known to buy their own company's stock after severe market drops and to sell during a market rally when their stock is overpriced. Due to its imprecise nature, trading solely on the basis of an Insider Trading Report is probably not the best course of action, but this information may be useful when used in conjunction with other analysis.

Short Sale Ratio
A commitment indicator relating to stock exchange members is the short sale ratio, which measures not only shorting by members and specialists, but also total shorting on a particular exchange. The short sale ratio is typically broken into the member short sale ratio (members to total shorting) and the specialist short sale ratio (specialists to members). These ratios have traditionally been used to show stock market tops and bottoms, but they have lost some utility lately because of the predilection to arbitrage skews the results. 

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Odd Lot Activity
The odd lot sales ratio measures the ratio of odd lot sales (which trade less than 100 shares of stock at a time) to odd lot purchases. Greater odd lot selling indicates that the market is near the top; odd lot purchases mean the market is near the bottom. The odd lot activity ratio has also lost usefulness lately for a number of reasons, not the least of which is that the New York Stock Exchange (NYSE) has established preferential treatment for odd lot orders, meaning that many professionals now trade in 99-share lots to ensure preferential fills for their orders.

In conclusion, commitment indicators run the gamut from commodity trading to equity trading, but they are certainly most valuable when used to glean information about the actions of professional commodity traders. Commercial traders, or hedgers, are distinguished by their rare ability to execute successful trades over time, and, as such, their actions are some of the best models for the individual small trader to mimic. 


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