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Sentiment Trading Strategies And Market Sentiment Indicators Explained

Last Updated on 10 February, 2024 by Trading System

Also known as investor attention or crowd psychology, market sentiment indicators refer to the prevailing attitude of investors as regards expected price development in a market. It is the feeling or tone of a market, as revealed through the activity and price movement of the securities traded in that market. Sentiment trading strategies and indicators are a variety of technical and statistical methods used to measure market sentiment. We provide you with several sentiment market indicators and backtests.

What is a sentiment indicator?

A sentiment indicator is any tool used to measure the mood of the market by analyzing trends, market activity, and the economy from the perspective of the participants involved, rather than just looking at an asset or data point isolation. Investors use sentiment indicators to gauge how optimistic or pessimistic people are about the current market or economic conditions.

There are various indicators they can use to measure market sentiment to know the best stocks to trade and when to trade them. Some of the most commonly used sentiment indicators include the CBOE Volatility Index (VIX), High-Low Index, Bullish Percent Index (BPI), and put/call ratio.

These sentiment indicators gauge market psychology in the form of investor behavior, but there are other sentiment indicators that monitor consumer behavior which is believed to influence the market. Typically, when a sentiment indicator is moving in the same direction as the market parameter it is analyzing, investors see it as a confirmation of the trend.

However, when the readings of a sentiment indicator are extreme readings, some traders may take a contrarian view of the market — for example, they buy when there is a high level of fear and sell when there is greed. Whichever way, it is not advisable to trade based on sentiment indicators alone. Combine them with technical and fundamental analysis.

Sentiment indicator trading strategies

As a trader or investor, it is necessary to understand the mood of the market at every point in time, and market sentiment can be a powerful tool for that. But what is market sentiment and how do you measure it?

Here you can find more than 200 trading strategies similar to the above strategies.

Eager to learn more, let’s dive in.

 

Sentiment indicators examples

How do you trade with sentiment? There are many types of sentiment indicators, but let’s take a look at these ones:

  • Advance/Decline (A/D) line: It plots the difference between the number of advancing and declining stocks on a daily basis. It tells traders whether there are more stocks rising or falling, so it is used to confirm price trends in major indexes — a rising A/D line during a rally confirms the uptrend, and a falling A/D line during a downtrend confirms the downtrend.
  • Put/Call ratio: It represents a proportion between all the put options and all the call options purchased on any given day. When it has a very high reading (relative to historical values) it shows investors are expecting stock market prices to decline. On the other hand, when it has a very low reading, it shows that prices will likely rise, as there are few people left to keep pushing prices lower.
  • CBOE Volatility Index (VIX): Often seen as the “fear index”, it rises sharply when investors purchase a significant amount of SPX put options to protect their portfolios. Investors buy put options when they believe the market is about to decline, so a spike in the VIX indicates fear within the market.
  • New York Stock Exchange (NYSE) High/Low Indicator: This compares stocks making new 52-week highs relative to stocks making new 52-week lows. A spike in either direction implies extreme bullishness or bearishness, which contrarian investors can use to trade in the opposite direction.

What is sentiment in the stock market?

How to measure market sentiment? In the stock market, sentiment is the prevailing mood of investors as regards the anticipated price development in a market. It is the tone of a market, as revealed by crowd psychology through the activity and price movement of the general market. Generally, rising prices indicate bullish market sentiment, while falling prices indicate bearish market sentiment.

Investors’ mood is a function of the accumulation of a variety of fundamental and technical factors, including price history, economic reports, seasonal factors, and national and world events. All these factors affect investors’ behavior and consequently, how the market moves. When investors are optimistic about the market, they keep buying, which pushes up the prices. On the other hand, when investors are pessimistic about the market, they sell their assets to stay in cash.

What does bearish and bullish sentiment mean?

Investors typically describe market sentiment as bearish or bullish. A bullish sentiment means investors expect upward price movement in the stock market. In such a situation, they are more likely to keep buying and pushing the price up. What is the best sentiment indicator?

A bearish sentiment, on the other hand, means that most investors expect the prices to decline, so they sell their assets.

Market sentiment indicators

There are plenty of market sentiment indicators. We have covered a few of them on this website. Let’s look at a few of them:

AAII Sentiment Indicators

AAII sentiment indicator is a widely used and referred to indicator.

AAII stands for American Association of Individual Investors. The index is updated once a week and shows the sentiment among the AAII members. We did a backtest to show the performance of the indicator:

Consumer confidence sentiment indicator

Consumer confidence reveals the “temperature” in the economy. Just like Mr. Market, the consumer confidence swings from one mood to the other – perhaps a bit manic depressive. Consumer confidence is published monthly by the Conference board.

We have backtested this sentiment indicator, and we found out that the stock market performs better when consumer confidence is bearish as a contrarian indicator.

Investors Intelligence Sentiment Index

Investors Intelligence Sentiment Index is also known as the Advisor Sentiment and is based on contrarian propositions. We have not backtested this indicator, but we made a summary in a previous post:

The Put Call ratio

The put call ratio looks at the relationship between the number of puts and calls (volume or open interest). There are many different puts and calls and hence you can choose among many ways to backtest.

Our own backtests on the put call ratio determine that there are better fear indicators out there:

We regard VIX as the best fear indicator:

VIX fear index

The VIX is an indicator that is based on the implied volatility of  S&P 500 options. The more fear in the market, the more traders and investors are willing to pay for insurance. Options work just like insurance. If you own put options you have the right to sell (but not the obligation) at a predetermined price (strike) within a certain timeframe (expiration date).

The implied volatility can be used as a fear indicator, thus S&P 500 and the VIX are inversely related. We have written many articles about the VIZ and below you find three articles including both backtests and strategies:

NAAIM Exposure Index

NAAIM is an abbreviation for National Association of Active Investment Managers (NAAIM). It measures the exposure to equities by its members by using a two-week average of the responses by the members. It’s mainly used as a contrarian indicator.

Is a sentiment based trading strategy profitable?

A sentiment-based trading strategy can be profitable for traders, but it also carries significant risks and challenges. This type of strategy relies on analyzing market sentiment, which is the collective mood and attitude of traders and investors, to make trading decisions. As you can see in our strategies and examples it is possible to make money and be profitable trading sentiment trading strategies.

Market Sentiment and Sentiment Indicators

The relationship between the stock market and sentiment is mostly inversely related and they could be used as contrarian indicators. However, we believe these indicators work better on longer term horizons – most likely many months. For short-term trading, we believe the “standard” oscillating indicators work better than sentiment indicators.

Sentiment Trading Strategies

Sentiment trading strategies are investment approaches that rely on analyzing market sentiment, which is the collective mood, attitudes, and emotions of market participants, to make trading decisions. These strategies aim to capitalize on the idea that investor sentiment can influence asset prices, sometimes leading to mispricing or trends that can be exploited for profit. Here are some common sentiment trading strategies:

  1. Contrarian Trading:
    • Buy Low, Sell High: Contrarian traders go against prevailing sentiment. When sentiment is excessively negative, they may buy an asset, expecting it to rebound as sentiment improves. Conversely, they may sell when sentiment is overly optimistic, anticipating a correction.
  2. Momentum Trading:
    • Follow the Trend: Momentum traders follow the direction of prevailing sentiment. If positive sentiment is driving an asset’s price up, they may buy in anticipation of further gains, and vice versa for negative sentiment.
  3. News-Based Trading:
    • Event-Driven: Traders react to news events and market sentiment shifts caused by news. This can involve trading on earnings announcements, economic data releases, or geopolitical events.
  4. Social Media Sentiment Analysis:
    • Sentiment from Social Media: Some traders use sentiment analysis tools to monitor social media platforms, such as Twitter or Reddit, to gauge public sentiment about specific assets. They may make trading decisions based on this data.
  5. Options Trading Strategies:
    • Implied Volatility: Options traders may use implied volatility as a gauge of market sentiment. High implied volatility suggests increased uncertainty, which can lead to options strategies like straddles or strangles.
  6. Sentiment Indexes:
    • VIX (Volatility Index): The VIX, often referred to as the “fear gauge,” measures implied volatility in the options market and can be used as a proxy for market sentiment. A high VIX indicates heightened fear or uncertainty.
  7. Technical Analysis with Sentiment Indicators:
    • Combine with Technical Analysis: Traders may combine sentiment indicators with technical analysis to make more informed decisions. For example, using sentiment data alongside moving averages or chart patterns.
  8. Market Sentiment Surveys:
    • Professional Surveys: Analysts and traders sometimes rely on market sentiment surveys to gauge the consensus opinion of market professionals. These surveys may help inform trading decisions.
  9. Behavioral Finance Insights:
    • Behavioral Biases: Sentiment trading also considers behavioral biases, such as herd behavior and overreaction to news. Traders may exploit these biases when making decisions.
  10. Quantitative Models:
    • Quantitative Sentiment Models: Some traders develop quantitative models that incorporate sentiment data, such as sentiment scores from news articles or social media, into their trading algorithms.

FAQ

What is market sentiment, and why is it important for investors?

Market sentiment, also known as investor attention or crowd psychology, reflects the prevailing attitude of investors towards expected price developments in a market. It’s crucial for investors as it can influence trading decisions and market trends.

How do sentiment indicators work, and why are they used in trading?

Sentiment indicators measure the mood of the market by analyzing trends, market activity, and the economy from the perspective of participants. Traders use these indicators to gauge optimism or pessimism about the current market or economic conditions.

How do sentiment indicators influence trading strategies?

Sentiment indicators can confirm trends, but extreme readings may lead traders to take a contrarian view. It explains the importance of combining sentiment indicators with technical and fundamental analysis for more informed trading decisions. The VIX is considered a “fear index” that rises when investors buy put options to protect portfolios during market declines. A high put/call ratio also indicates fear, as investors anticipate stock market prices to decline.

What is the relationship between sentiment and stock market movements?

Sentiment is inversely related to stock market movements. Sentiment indicators can act as contrarian indicators, and their effectiveness may vary over different time horizons.

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