A Better Tool To Understand Investor Psychology
In the 1930s, a financial editor at Forbes magazine pieced together chart patterns. Richard Schabacker, considered to be 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. 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 breaks and prices start moving higher, we often see a “market melt up”. This happens when investors rush in, worried about missing out on the upside.
This is an oversimplification, but investor psychology does help us understand a great deal about the market action. Charles Dow, the creator of the Dow Jones Industrial Average, recognized this idea more than a century ago. In short, Dow noticed that bull markets start when investors are gripped with a sense of doom. And they end in euphoria.
Over the years, this insight has led to the development of a number of trading techniques. It’s easy to forget, but charts were the original trading tool. But some analysts wanted more precise signals, so they developed technical indicators based on the price action.
Technical Tools For Understanding Investor Psychology
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 oversold or overbought conditions in the market. In practice, oversold markets tend to drop lower than expected. And overbought indicators can 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 usually time to be bullish. When most traders develop a sense of complacency, it is usually time to worry about a bear market.
The CBOE Volatility Index (VIX), or “Fear Index,” is an indicator that measures 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 thousands of stocks trading in the market. So, what if there were an indicator that acts like VIX for individual stocks and could provide trading signals?
Introducing: The ITV Indicator
Below is a chart of the Income Trader Volatility (ITV) indicator, which was developed by our colleague Amber Hestla. She uses it regularly in her premium service, Income Trader.
We’ll save the details for now. Just know that ITV is 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. It simply shows where the current close is relative to the recent price action.
We can apply a 20-week moving average (MA) to ITV to generate trade signals. When volatility rises, ITV (gray line) crosses above the MA (green dotted line). That is a sell signal. When volatility falls, ITV falls below the MA. In other words, the it buys when fear (ITV) is high but beginning to decrease. It sells when fear (ITV) starts rising. Of course, 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 believe they should serve as the basis of original research. Don’t expect them to simply work just as well as they once did.
Years ago, our colleague Amber Hestla left the military to study under some of the world’s foremost trading experts. After years of study, she developed the ITV indicator. Not only did Amber’s ITV indicator win the prestigious Charles H. Dow award, but it’s delivered winning options trades year after year.
Another proven technique Amber uses works like an “insurance” plan for your stocks…
It allows you to get paid instantly, rather than sit around and wait. Her subscribers have been trading this way for years, allowing them to pocket hundreds (or even thousands) of dollars with very little effort.
If you’re looking to earn more income in 2021 than you ever thought possible, then you should learn more about how this works. You can check it out right here.