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Monday, December 30, 2013 - 07:00

Profit From Investor Fear With This Simple Tool

Monday, December 30, 2013 7:00 AM

In the 1930s, a financial editor at Forbes magazine pieced together chart patterns. Richard Schabacker, who is considered the father of technical analysis, went beyond identifying how patterns looked on charts. He also looked broadly at investor psychology and noticed that it could explain why some chart patterns form.

Psychology can be a valuable tool for traders to understand. We have made some notes on the chart below that describe the feelings of some investors at various times during the past few years.

Investor psychology does help explain resistance on a chart, for example. After a bear market, there will be some investors who will be thankful to recover their losses. They might sell when the market gets back to its old highs. This appears as resistance on the charts. After resistance is broken and prices start moving higher, we often see a market "melt-up" as investors rush in since they are worried about missing out on the upside.

This is an oversimplification, but investor psychology does help us to understand a great deal about the market action. This idea was also recognized more than 100 years ago by Charles Dow, the creator of the Dow Jones Industrial Average. Dow noticed that bull markets start when investors are gripped with a sense of doom and end in euphoria.

Over the years, this insight has been used to develop a number of trading techniques. Charts were the original trading tool, but some analysts wanted more-precise signals and developed technical indicators based on the price action.

Stochastics and Moving Average Convergence/Divergence (MACD) are examples of indicators that attempt to measure investor psychology by showing when price moves reflect excessive levels of pessimism or optimism. In theory, these indicators show when prices are oversold or overbought. In practice, oversold markets tend to drop lower than expected and overbought indicators may signal the beginning of a new bull market.

While the most widely followed indicators seem to be among the least useful, the theory behind them is valuable. When most traders are fearful, it is time to be bullish, and when most traders develop a sense of complacency, it is time to be worried about a bear market.

The CBOE Volatility Index (VIX) is an indicator that was specifically designed to measure fear and complacency. The indicator uses options prices to track what investors are willing to pay for downside protection to hedge their portfolios with S&P 500 options.

As useful as tracking volatility is, VIX only applies to the S&P 500 Index. It rarely provides trading signals, and it never tells us anything about individual stocks. There are more than 7,000 stocks trading in the stock market. So, what if there were an indicator that acts like VIX for individual stocks and could provide trading signals?

Below is a chart of the Income Trader Volatility (ITV) indicator, a new idea based on the old ideas of VIX and investor psychology.

As you can see in the chart below, when ITV is applied to SPDR S&P 500 (NYSE: SPY), it closely mirrors VIX. Unlike VIX, however, ITV can be calculated for any stock, as it simply shows where the current close is relative to the recent price action.

We apply a 20-week moving average (MA) to ITV to generate trade signals, and several signals are shown in the chart of Apple (Nasdaq: AAPL) below.

When volatility rises, ITV (gray line) crosses above the MA (green dotted line), and that is a sell signal. Buys are given when ITV falls below the MA. In other words, the rules buy when fear (ITV) is high but beginning to decrease. It sells when fear (ITV) starts rising. Not all trades are winners, but ITV consistently puts us on the right side of big moves.

Action to Take --> ITV is an example of a new indicator based on old ideas. Many of the original insights developed in the 1930s or earlier are useful, but we think they should serve as the basis of original research rather than rules that are expected to work just as well as they once did.

This article was originally published at ProfitableTrading.com:
Little-Known Indicator Signals 'Buy' While Investors Are Running Scared

P.S. Amber regularly uses the ITV indicator in her Income Trader advisory when she searches for the best options plays each week. A testament to the power of this indicator is her track record -- all 33 of her closed positions are winners. Even more impressive, Amber's Instant Income trades generate an average of 8.6% every 48 days. Click here to learn more.

Amber Hestla, Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.