What is market sentiment and how do you trade it?

Market sentiment refers to the overall attitude or feeling of market participants toward a specific asset or the broader financial market. Sentiment is driven by various factors such as economic data, news, earnings reports, geopolitical events, and market speculation.

Market sentiment in trading represents the mood of the market. When the market is bullish, the sentiment is positive, and investors believe prices will rise. Conversely, a bearish market means investors are pessimistic and expect prices to fall. Sentiment is typically gauged through price action and various sentiment indicators.

How does market sentiment differ from market analysis (Fundamental or Technical)?

Market sentiment differs from fundamental and technical analysis as it focuses on the emotional and psychological aspects of market participants, rather than on objective data or patterns. While fundamental analysis evaluates the intrinsic value of an asset using economic data, earnings reports, and other factual information, and technical analysis studies historical price movements and patterns, sentiment analysis looks at the collective feelings and biases of investors.

What factors influence market sentiment?

Market sentiment is driven by several factors:

• Economic Data: Reports like GDP, inflation, and employment impact how traders view market strength.
• Central Bank Policies: Interest rate changes or monetary policy shifts influence sentiment by affecting borrowing and investment.
• Geopolitical Events: Wars, elections, trade disputes, and other global developments create uncertainty or optimism.
• Corporate Earnings: Strong or weak company earnings reports affect confidence in specific sectors.
• News and Media: Headlines and breaking news can quickly shift sentiment, driving emotional reactions.
• Technical Indicators: Price trends, volume, and chart patterns guide traders' perceptions of future market moves.

How does market sentiment reflect the emotions of market participants?

Market sentiment directly reflects the collective emotions of investors - whether they feel optimistic, fearful, or greedy. When market participants feel confident about the future, prices tend to rise, and when they’re fearful or uncertain, they sell assets, causing prices to drop. Understanding the emotional drivers behind sentiment can help traders anticipate potential price moves.

What is the role of news and social media in shaping market sentiment?

News and social media play a significant role in shaping market sentiment by quickly disseminating information that influences traders' emotions and decisions. Breaking news can trigger immediate market reactions, driving optimism (bullish sentiment) or fear (bearish sentiment). Social media amplifies this by rapidly circulating opinions, unconfirmed speculation, and analysis, often intensifying emotional responses.

Source - trading view

For example, on November 18, 2020, an FT journalist tweeted about Pfizer-BioNTech’s COVID-19 vaccine being 90% effective, which sent waves of optimism through global markets. The Dow Jones rose over 800 points that day (see chart above), and stocks in travel and hospitality surged. Overall, the announcement was a pivotal moment that led to increased investor confidence and contributed to a bullish trend in the markets in the weeks and months that followed (see chart below).

Source - trading view

What tools and indicators can be used to measure market sentiment?

There is a comprehensive list of tools and indicators that can be used to gauge market sentiment:

Surveys and Polls

Consumer Confidence Index (CCI): Measures overall consumer sentiment regarding the economy.

Investor Sentiment Surveys: Conducted by organisations like the American Association of Individual Investors (AAII) to gauge bullish or bearish sentiment among investors.

University of Michigan Consumer Sentiment Index: Reflects consumer attitudes and expectations about the economy.

Market Sentiment Indicators

• Fear and Greed Index: A composite index from CNN that measures market sentiment on a scale ranging from extreme fear to extreme greed, based on various factors. High levels of greed often signal market tops, while high levels of fear can indicate potential buying opportunities, as fear-driven sell-offs may result in undervalued assets.
• Market Volatility Index (VIX): Known as the "fear index," it measures market expectations of future volatility based on options pricing.
• Put/Call Ratio: Indicates investor sentiment by comparing the volume of put options to call options. A high ratio may indicate bearish sentiment, while a low ratio indicates bullish sentiment.
• MOVE Index: Measures the implied volatility of the U.S. Treasury options, reflecting sentiment regarding interest rate fluctuations and bond market stability.
• Bullish Percentage Index (BPI): Indicates the percentage of stocks in a specific index that are on bullish signals, such as buy signals based on point and figure charts. A high BPI (typically above 70%) suggests strong bullish sentiment, while a low BPI (below 30%) indicates bearish sentiment.

Technical Analysis Tools

• Moving Averages: Analysing trends in moving averages (e.g., 50-day, 200-day) can help gauge overall market sentiment.
• Stocks Above/Below 200 DMA: This metric shows how many stocks are trading above or below their 200-day moving average, indicating overall market strength or weakness. A high percentage of stocks above the 200 DMA suggests bullish sentiment, while many stocks below it can indicate bearish sentiment.
• Relative Strength Index (RSI): Measures the speed and change of price movements, indicating whether an asset is overbought or oversold, reflecting sentiment.

Market Breadth Indicators

• Advance-Decline Line: Tracks the number of advancing stocks versus declining stocks to assess market strength.
• New Highs/New Lows Index: Compares the number of stocks reaching new highs against those reaching new lows, providing insight into market sentiment.

Volume Indicators

• On-Balance Volume (OBV): Combines price and volume to show how volume is influencing price trends.
• Accumulation/Distribution Line: Measures the cumulative flow of money into and out of a security, indicating sentiment.
• Smart Money Index: This index tracks the flow of funds into and out of the market, reflecting the behaviour of institutional investors (often referred to as "smart money"). A rising SMI suggests that institutional investors are optimistic, while a declining SMI can indicate bearish sentiment.

Using a combination of these tools and indicators will provide a well-rounded understanding of market sentiment, helping traders make more informed decisions.

How do sentiment indicators like the CBOE volatility index (VIX) or put/call ratios work?

VIX (Volatility Index)

The VIX is often referred to as the "fear gauge". It measures expected price volatility in the S&P 500 over the next 30 days. A high VIX indicates fear or uncertainty, while a low VIX signals complacency.

Example: VIX Spike During the 2018 Market Correction

Source - trading view

In early 2018, market fears over rising interest rates caused a sharp correction in U.S. stocks. On February 5, the VIX spiked to around 37, one of the largest one-day increases in its history. This spike reflected extreme fear, leading to a nearly 10% drop in the S&P 500.

Put/Call Ratio

The Put/Call ratio compares the volume of put options to call options. A high put/call ratio signals bearish sentiment, as more investors are betting on price declines, while a low ratio suggests bullish sentiment. The Put/Call Ratio is above 1 when put volume exceeds call volume and below 1 when call volume exceeds put volume.

Example: August 2010 Market Correction

Source - trading view

During the 2010 market correction, the put/call ratio spiked to over 3.0 as investors hedged against declines driven by the European debt crisis. This indicated that for every call option traded, there were over three put options being traded, reflecting extreme bearish sentiment among investors. Such a high put/call ratio signals that traders were heavily hedging against potential market declines, indicative of heightened fear and uncertainty. This surge in bearish sentiment contributed to a 6% drop in the S&P 500 over the next two weeks.

Can you trade based on sentiment analysis alone, or should it be combined with other forms of analysis?

While sentiment analysis can provide insights into the emotional state of the market, it's most effective when combined with other forms of analysis like technical and fundamental analysis. Trading solely on sentiment can be risky as it doesn’t account for objective market data. Incorporating market sentiment into a broader strategy can help traders better understand potential reversals or trends.

What are the limitations of market sentiment indicators?

Market sentiment indicators have several limiting factors, including:

• Subjectivity: Sentiment is influenced by emotions and can be irrational.
• Lagging: Sentiment indicators often reflect past or current conditions, making them less reliable for predicting future price movements.
• False Signals: Sentiment can be overly optimistic or pessimistic, leading to false breakouts or breakdowns.

How can market sentiment influence price trends and reversals?

Market sentiment can drive price trends when it’s overwhelmingly bullish or bearish. For example, excessive bullish sentiment can lead to overbought conditions, potentially triggering a reversal. Similarly, extreme bearish sentiment may create oversold conditions, prompting a bullish reversal. Tracking sentiment shifts can help traders identify potential trend changes.

What are common strategies traders use to trade based on market sentiment?

Common sentiment-based trading strategies include:

• Trend Following: Traders follow the prevailing sentiment (bullish or bearish) until a reversal is indicated.
• Contrarian Trading: Traders take positions against the prevailing sentiment, buying when sentiment is overly bearish and selling when sentiment is excessively bullish.
• Sentiment Reversals: Traders look for extremes in sentiment indicators, such as an overly high VIX or put/call ratio, to predict trend reversals (see How Do Sentiment Indicators Like the CBOE Volatility Index (VIX) or Put/Call Ratios Work? above)

What risks should traders be aware of when trading based on market sentiment?

When trading based on market sentiment, traders should be aware of the following risks:

• Emotional Bias: Market sentiment can lead to emotional decision-making, resulting in impulsive trades rather than data-driven analysis.
• Overreaction: Traders may overreact to news or events, causing unnecessary volatility and potential losses if the sentiment shifts quickly.
• False Signals: Sentiment indicators may produce misleading signals, leading traders to enter positions based on inaccurate readings.
• Market Manipulation: Sentiment can be influenced by rumours, social media, or misinformation, leading to distorted perceptions and irrational trading behaviour.
• Timing Issues: Trends based on sentiment may not align with fundamental factors, resulting in poor timing for entry or exit points.
• Liquidity Risks: Trading in highly sentiment-driven environments can lead to lower liquidity, making it difficult to execute trades at desired prices.
• Short-Term Focus: Focusing too much on sentiment can lead to neglecting long-term strategies, increasing the risk of losses during market corrections.
• Herd Behaviour: Following the crowd can result in buying high or selling low, which may contradict individual trading strategies and lead to significant losses.
• Psychological Pressure: Constantly monitoring sentiment can create anxiety, affecting a trader's ability to make rational decisions.

How does market sentiment differ across asset classes like forex, stocks or commodities?

• Forex: Sentiment is often influenced by macroeconomic data, interest rates, and central bank actions.
• Stocks: Corporate earnings, news, and broader economic indicators drive sentiment.
• Commodities: Supply and demand factors, as well as global trade conditions, shape sentiment.

How does sentiment impact short-term vs. long-term trades?

• Short-Term Trades: Sentiment can significantly impact short-term trades, with traders capitalising on rapid sentiment shifts.
• Long-Term Trades: For long-term trades, sentiment tends to play a secondary role to fundamentals, though prolonged bullish or bearish sentiment can influence market trends over time.

Can you use sentiment analysis to predict market crashes or corrections?

Sentiment analysis can provide clues to potential market crashes or corrections when indicators like the VIX or fear/greed indices signal extreme fear or complacency. However, while sentiment can give early warning signs, it's not foolproof and should be used alongside other predictive tools.

How can I incorporate sentiment analysis into my current trading strategy?

Traders can incorporate sentiment analysis by:

• Monitoring Sentiment Indicators: Regularly reviewing the VIX, put/call ratios, or sentiment surveys.
• Confirming with Other Analysis: Combining sentiment insights with technical and fundamental analysis to reinforce trade decisions.
• Staying Agile: Adjusting positions based on shifts in sentiment while adhering to broader trading strategies.

What role does market sentiment play in day trading vs. swing trading?

Day Trading: Sentiment plays a critical role in short-term price moves, with day traders relying on sentiment shifts for quick trades.

Swing Trading: Sentiment still matters but is combined with longer-term technical and fundamental trends for holding positions over days or weeks.

What are the best sources for tracking real-time market sentiment?

Top sources for tracking market sentiment include:

• News Outlets: Bloomberg, Reuters, and CNBC provide up-to-date news.
• Sentiment Surveys: AAII, Investors Intelligence.
• Social Media: Twitter, Reddit, and platforms like StockTwits.
• Market Data Platforms: Pepperstone, TradingView.

By integrating sentiment analysis into their overall approach, traders can gain valuable insights into potential market moves and better navigate periods of high volatility. Understanding market sentiment allows traders to adapt their strategies to both emotional market conditions and the objective factors driving them.