V13:06: (255-259): Back Testing The Daily Sentiment Index by Lee Ang

V13:06: (255-259): Back Testing The Daily Sentiment Index by Lee Ang

Market traders and advisors use sentiment surveys as a tool to identify extreme bullishness or bearishness. Here, then, is one trader's research into identifying what the best levels of a sentiment survey are for trading Treasury bond futures.

The daily sentiment index (DSI) is based on nonprofessional speculators' opinions of futures markets. Its creator, market timer Jake Bernstein of MBH Commodity Advisors, surveys nonprofessional traders at the end of each trading day regarding their level of bullish sentiment for each futures market and publishes the results after the markets close via a hotline, fax service and computer bulletin board. This index ranges from one to 100, in which a reading of 80 to 100 indicates that most of the respondents are extremely bullish, while a reading from one to 20 signifies that most respondents are extremely bearish. A reading of 50 would mean that the respondents are relatively neutral about the general market direction.

Traders normally use the DSI as a contrarian tool. The logic behind doing so is that when everyone agrees on market direction, the market usually moves in the opposite direction because the current price has adequately discounted the prevailing sentiment. Thus, a reading of 25 or below is considered to be a bullish reading, while a reading of 75 or above is taken to be a bearish indication.

Is the DSI a good contrarian tool? To find out, let's focus whether the daily sentiment index is effective as a trading tool for US Treasury bond futures. Before we go into that, however, let us explore the DSI's trading strategy and start with back-testing assumptions, using Logical Information Machine (LIM) software on a workstation to do so.