Last Updated on 21 September, 2020 by Therobusttrader
Anything that can help you make better trading decisions and improve your returns is worth looking into, and market sentiment indicators may be one of those things. But can market sentiment indicators really help your trading?
Market sentiment indicators can help your trading if you understand what they measure and use them in the right way. On their own, market sentiment indicators most times cannot tell you exactly when to buy or sell a security, but when used together with either technical or fundamental analysis or both, they can significantly improve your trading decisions.
Surely, you would like to know how to improve your trading with market sentiment indicators, but first, let’s find out what the sentiment indicators are.
What Are Market Sentiment Indicators?
Market sentiment indicators are those indicators that show the collective perception of investors and traders about a market. In other words, they are used to show what the market participants believe about the likely direction of the market, as demonstrated by the predominating positions in the market and how those positions will affect future price behavior.
To fully grasp what market sentiment indicators are and how they are derived, we need to understand the idea of market sentiment.
What Is Market Sentiment?
Also known as investor sentiment or investor attention, market sentiment is the prevailing attitude of market participants regarding the anticipated movement in the price of a particular financial security. By sentiment, we mean the psychology of the crowd that makes up the market and how it influences their actions toward a particular financial instrument.
Thus, market sentiment is the collective feeling of the market, as revealed by the way the prices of various securities in the market are moving. It reflects the accumulation of all the factors that affect price movements, such as technical factors, seasonal effects, economic reports, political events, and other fundamental factors that may influence a security’s price.
Bullish and Bearish Sentiment
Generally speaking, when the market participants are expecting the price to move upward, we say the market sentiment is bullish, and if, on the contrary, the majority of the investors are betting on downward price movement, we say the market sentiment is bearish.
Market participants are often described according to their view of the market. Those with bullish sentiment are called bulls, while those with bearish sentiment are called bears. So when bulls are dominating, the market is going up, and when the bears are dominating, the market is going down.
Now, you can appreciate the fact that market sentiment indicators are tools to measure investors’ expectations in the market. They are statistical tools designed to graphically or numerically show the predominating attitude of the market participants. A market sentiment indicator can show how bearish or bullish the investors are, which may indicate their future course of action.
Certain market sentiments indicators can show the raw data or the percentage of trades that are placed in either direction — long or short — in the market. For instance, say out of 1000 trades on a particular stock, long positions are 300, while short positions are 700. There are more bears than bulls, so the market sentiment is bearish.
The main value of the sentiment indicators lies in detecting when the sentiment in the market reaches an extreme level. In such situations, the sentiment indicators can help a trader take a contrarian position. So assuming that 900 out 1000 trades are short positions, there may not be plenty more orders to push the price further down, and the short positions will still have to buy to cover their shorts. Thus the chances of a bullish reversal are very high.
In other words, market sentiments indicators can give useful contrarian signals. Some of the common market sentiment indicators are
- the commitment of traders report (COT)
- put/call ratio
- VIX, Trin Index
- upside/downside volume ratio
- advance/decline ratio
- NYSE high/low ratio
- NYSE bullish percent index
Let’s now have a look at these indicators, and what they tell you about the market!
Common Market Sentiment Indicators
There are different kinds of indicators you can use to gauge the investor sentiment. Each one is unique in its own way and tells a specific story about what is happening in the market. So you can use more than one in your analysis or combine them with your technical analysis tools.
Here are some of the most common market sentiment indicators:
1. Advance/Decline Ratio (ADR)
This is a well-known market breadth indicator that traders use to estimate investor sentiment. The ADR compares the number of stocks that closed above the previous session’s closing price to the number of stocks that closed lower. It can be calculated for any timeframe — daily, weekly, and monthly.
To get the ADR, you divide the number of stocks that closed higher by the number of stocks that closed lower.
The ratio makes it easier to know how the entire market played out during the session, especially when used together with a broad market index. If a broad index, such as S&P 500 Index, closed higher and the ADR is more than 1, it means that the Index’s advance was driven by the majority of the stocks in the market, so the market is generally bullish.
Conversely, if the Index is advancing but the ADR is less than 1, the market advance is driven by a minority of stocks in the market, indicating a weakness in the up move and a potential market reversal. The opposite is the case for a declining broad-market index.
Some investors use a moving average of the ADR to smoothen the data. Others use a different version of the indicator called the advance/decline index or advance/decline line. The A/D index measures the cumulative difference between the number of advancing stocks and the number of declining stocks.
2. Up/down Volume Ratio
Commonly known as the upside/downside volume ratio or the advance/decline volume, the up/down volume ratio compares the volume of stocks that closed higher for the day with the volume of stocks that closed lower.
The up/down volume ratio is calculated by dividing the total volume of stocks that closed higher by the total volume of stocks that closed lower.
Traders use the ratio to estimate the sentiment of market participants. When the ratio is more than 1.0, it means that the stocks that closed higher traded more shares than the stocks that closed lower, and it is normally seen as a bullish signal. A value of less than 1.0 indicates that there was more volume associated with the stocks that closed lower than those that closed higher, and it is seen as a bearish signal.
The ratio can be used with trend following strategies to confirm that the broad market is showing strength in the direction of the trend. Contrarian traders can also use it to confirm overbought and oversold situations in the market — very low values are may indicate oversold, while very high values indicate overbought levels.
3. Trin Index
Invented in 1967 by Richard W. Arms, the Short-Term Trading Index (TRIN) is also called the Arms Index. Traders use it to estimate general market sentiment by measuring the relationship between market supply and demand. The Arms Index is calculated by dividing the advance/decline ratio with the up/down volume ratio.
Traders use it to predict future market movement by comparing it with the stock market index, such as the S&P500 Index. When the Arms Index is higher than 1.0 and the stock market index is declining, it shows a bearish sentiment. However, when the value is quite high — say 3.0 and above — the market could be oversold, and a bullish reversal may be around the corner.
On the other hand, a value of less than 1.0 and an ascending composite index imply that there is a bullish market sentiment. But if the value gets below 0.5, the market may be overbought and probably about to reverse.
The CBOE Volatility Index (VIX) measures investors’ expectations of adverse market movement in the future. It is often called the fear index since it increases when there is extreme pessimism in the market. The VIX is calculated from call and put options prices of the S&P 500 Index options (SPX), but the put options prices carry greater weight.
VIX is based on the fact that investors buy put options to protect their portfolio from adverse price movements. When institutional investors think that the market will significantly decline, they rush to the options market to hedge their portfolio by buying put options. The huge demand for put options drives the prices higher, causing the VIX to spike. Thus, a rising VIX implies a bearish market sentiment.
On the other hand, a falling VIX indicates that the investors are confident and not expecting adverse fluctuations. But the VIX is normally mean-reverting in the medium and long term, so extreme values may indicate potential stock market reversals.
If you want to find out more about the VIX, then we suggest that you have a look at our massive guide to VIX!
5. Put/call ratio
This is one of the market sentiment indicators that can be used to directly gauge investor sentiment in an individual stock. The put/call ratio compares the volume of put options on a security to the volume of call options on that security, over a trading session. It tries to estimate the level of bullishness or bearishness in the security.
The put/call ratio can be calculated for any security with tradable option contracts — individual stocks, stock indexes, commodities, and others. When it is calculated for a broad-market index, like the S&P 500, it can show the general market sentiment, but when it is calculated for a single stock, it shows investors’ attitude towards that stock.
Put options are often bought to hedge against downward price movements, while call options are bought by investors when they expect an upward price movement. So a higher proportion of puts relative to the calls show that investors are bearish, while a higher proportion of calls relative to puts indicate that the investors are expecting the price to move higher.
6. NYSE High/Low Ratio
The NYSE high/low indicator compares the number of stocks that are making new 52-week highs to the number of stocks that are making new 52-week lows. Traders use the high/low indicator to gauge market sentiment. The more the number of stocks hitting 52-week highs, the more bullish the market sentiment is. When more stocks are hitting 52-week lows, the market sentiment is bearish.
Most times, a 10-period, a simple moving average of the high-low differentials or the record high percent (percentage of new highs to the total of new highs and new lows) is used. A reading of less than 30 shows that more stocks are trading near their lows, while above 70 shows that more stocks are trading near their highs.
The indicator is often used alongside a broad-market index (S&P 500 Index or Nasdaq 100 Index). When the indicator and the broad-market index are moving in the same direction, the trend is strong. What this means is that if the market index is making a new high, the high/low indicator should be rising too — showing that more stocks are making new highs than new lows. The same is true in a downtrend.
If, on the contrary, the high-low indicator is diverging from the broad-market index, the trend is not healthy. That is, if the stock index is making a higher high but the high-low indicator is making a lower high, there may be a potential bearish reversal. Similarly, a lower low in the stock index and a higher low in the high-low indicator may show a potential end to a downtrend.
7. NYSE Bullish Percent Index (NYSE BPI)
The NYSE bullish percent index measures the percentage of stocks in the NYSE composite index that show bullish patterns based on point and figure charts. Although it is used to track all stocks quoted on the NYSE, it can be used on just the stocks that make up a broad market index or even a sector index.
Being an oscillator, the bullish percent index can display overbought and oversold levels. Its value normally ranges from 0 to 100 — with 50% indicating neutral market sentiment. When it reads 20% or lower, it means that the market sentiment is extremely bearish and may already be oversold.
On the other hand, when the BPI reads 80% or above, it means that investors are too optimistic about the market, and the market may already be overbought. But that the indicator is showing oversold or overbought doesn’t mean that the market must reverse immediately — the indicator can be in that region for an extended period without the market reversing.
8. NYSE 50-day moving average
This is a market breadth indicator that shows the percentage of all the stocks on the NYSE that is trading above their 50-day moving averages. For instance, if the indicator reads 64%, it means that about 64% of all the stocks on the NYSE are trading above their various 50-day moving averages, and it shows that the market is bullish. A reading of less than 50% shows that the market is bearish.
The 50-day moving average is seen as a short-to-medium-term moving average, so it is used to measure market sentiment over the short or medium term. Just like most other breadth indicators, this indicator can show overbought and oversold levels.
When it is reading above 80%, too many stocks are trading higher, and the market may be overbought. Conversely, a reading below 20% means that few stocks are trading above the 50-day moving average, and the market may be oversold.
9. NYSE 200-day moving average
The indicator measures the number of stocks trading above their 200-day moving average, expressed as a percentage of the total number of stocks on the NYSE. Since the 200-day moving average is seen as a long-term moving average, the indicator measures the market sentiment over the long term.
When more than 50% of the stocks on the exchange are trading above their 200-day moving averages, the long-term sentiment of the market is bullish, and when less than 50% of the stocks are trading below their 200-day moving averages, the long-term sentiment is bearish.
However, extreme values may indicate contrary signals — a reading below 20% may mean that stocks are oversold, while a reading above 80% may indicate that the market is overbought.
10. Odd-Lot Trading Statistics
This is a market sentiment indicator that shows the number of shares transacted in odd lots. An odd lot is a transaction involving less than 100 shares of a stock. The interpretation of the indicator is based on the assumption that the small investors, who normally don’t have enough investment capital, trade odd-lot sizes, and they don’t know what they’re doing — more likely to buy in an overbought market and sell in an oversold market.
Thus, when there is an increase in odd-lot trading in an overbought market, it may be a time to take the contrarian position and sell. Conversely, if the market is oversold and odd-lot trading is high, it may be time to start buying.
11. The Commitment of Traders Report
The Commitment of Traders (COT) report is a weekly report published by the Commodity Futures Trading Commission that shows the position of different types of traders in the U.S. futures market. It is released every Friday at 3:30 ET, but it shows the positions of the various trading groups as of Tuesday the same week.
There are two types of the report: the legacy COT and the disaggregated COT. The legacy COT shows the open-interest positions of all major contracts with more than 20 traders and breaks them down into short, long, and spread positions. It also classifies the positions according to commercial traders, non-commercial traders, and non-reportable small traders.
The disaggregated COT report further breaks down the various traders — the non-commercial traders are broken down into managed money and others, while the commercial traders are split into producers, users, merchants, processors, and swap dealers.
Because futures contracts are traded on an exchange, the COT report gives up-to-date information about traders in the futures market. Traders use the report to get an overview of the general market sentiment. A growing commercial and non-commercial long positions may indicate a bullish sentiment in the underlying asset, while increasing short positions may imply a bearish sentiment.
How Can Traders Benefit From Market Sentiment Indicators?
The aim of trading is to successfully time the market and make superior returns to those of passive investing. To beat the market, a trader needs to have a valid edge in the market. While the majority of traders use either technical or fundamental analysis to define their edge, market sentiment indicators can complement any of those approaches and improve the odds of any particular edge.
Depending on the type of market, sentiments analysis can show you what every other person in the market is doing. You can use it in conjunction with your preferred method of analysis to enhance your trading decisions and improve the outcome of your trades.
Generally, a trader can use a market sentiment indicator to do any of the following:
1. Confirm Price Reversal
Market sentiment indicators can help a trader confirm if the market trend has actually reversed. If a broad-market index, such as the Standard & Poor’s 500 or NASDAQ 100, changes direction, you can use a market sentiment indicator to confirm the reversal by checking whether the sentiment indicator agrees with the new direction.
For example, if the S&P 500 has been in a downtrend and later turns upwards, the number of advancing stocks are supposed to start increasing, while the number of declining stocks should be decreasing. In other words, some traders might want the advance/decline ratio to start increasing to confirm a new trend direction.
2. Gauge the Strength of a Trend
The strength of a general market trend can be estimated from the sentiment indicators. When there is a strong trend, the market sentiment indicators should be showing some strength in the direction of the trend. If not, the trend may not be healthy.
Using the NYSE high/low ratio as an example, if the S&P 500 Index is in an uptrend, the NYSE high/low ratio should be going up too — more stocks should be making new 52-week highs than the number of stocks making 52-week lows. And if the S&P 500 Index is in a downtrend, the NYSE high/low ratio should be decreasing, with more stocks making new lows than those hitting new highs.
3. Identify Market Extremes
Market sentiment indicators can help you identify when the market is generally in an extreme condition — overbought or oversold. A high reading on a market sentiment indicator may indicate that the market is overbought or oversold, depending on the type of indicator.
For example, for the NYSE bullish percent index, a very high reading could mean that the market is overbought, while a very low reading may indicate an oversold market. But for the VIX or Trin index, a very high reading would indicate an oversold market, while a very low reading may mean that the market is overbought.
4. Indicate Potential Price Reversals
Not only do the market sentiment indicators help in identifying extreme market conditions, but they can also show the first signs of potential price reversals. Although an oversold or overbought reading may make some traders want to look for positions in the opposite direction, another good sign of a potential market reversal is divergence.
When a market sentiment indicator is diverging from the broad-market index, a market reversal may be around the corner. For example, if the S&P 500 Index is making a higher high and the upside/downside volume ratio is making a lower high, the upside potential of the market is weak, and it may be about to head south.
5. Know When to Adopt a Contrarian Position
One of the main uses of market sentiment indicators is to have an idea when to start thinking of taking opposite positions to the crowd. If, for example, the commitment of traders report shows that 90% of traders are already short, it may be wise to start looking for opportunities to go long rather than go short.
Conversely, if the report shows that 90% of traders are long, looking for opportunities to go short becomes a better idea. Therefore, the market sentiment indicators are very helpful to contrarian traders and those who employ mean-reversion trading strategies.
However, sentiment indicators might not be very useful when used alone — they often work better when combined with other forms of analysis, like the technical analysis or fundamental analysis.
What’s the Difference Between Sentiment Indicators and Technical Indicators?
Sentiment indicators may appear similar to technical indicators because they all try to forecast future price movement using previous market data, but they differ in a few ways.
Firstly, sentiment indicators mostly make use of data from the entire market rather than data from a single security. Technical indicators, on the other hand, make use data from individual securities, such as an individual stock or a particular futures contract.
Secondly, because of the type of data used, market sentiment indicators, most of the time, provide information about the market at large. That is, sentiment indicators show the collective attitude of the traders towards the entire market. On the other hand, technical indicators are used to analyze individual stocks or future contacts to show what is happening in that particular stock or contract.
Tips on How to Use Sentiment Indicators in Trading
While market sentiment indicators can be very helpful in understanding what is happening in the market, they cannot help you improve your trading outcome if you do not know when and how to use them. Here are tips on how to use market sentiment indicators to improve your trading:
Know your market: It is very important that you understand the nature of the market you are trading — know what works and what does not in that market. Not all sentiment indicators are helpful in every market. For example, the ADR may be very helpful to a stock trader, but it may not be useful to a forex trader.
Know what your sentiment indicator does: Before you decide to make use of any market sentiment indicator in your trading, you must make sure you know everything about that sentiment indicator — what it measures, how it is calculated, and what it tells you about the market. This way, you know exactly what you are getting and if it is useful to you.
Use up to two sentiment indicators: It may be helpful to use more than one market sentiment indicators in your analysis, especially the ones that are not related in any way. When you use different indicators, you will be able to analyze investor sentiment from different perspectives
Combine with other analysis: It can be hard to make sentiment indicators work as stand-alone trading strategies. The best way to use them is in conjunction with other forms of analysis — fundamental and/or technical analysis. For example, sentiment indicators can help you to confirm your analysis or show when to look for trade setups.
Know the limit: There is no holy grail in trading — no matter how well you analyze the market, you will never win all your trades. You will win some and lose some. Knowing this can help you achieve some peace. Just find your edge and place your trades — if you truly have an edge, you will make money from the market.
Market sentiment indicators can help your trading if you understand what they measure and use them in the right way. On their own, market sentiment indicators most times cannot tell you exactly when to buy or sell a security, but when used together with either technical or fundamental analysis or both, they could significantly improve your trading decisions.