Last Updated on 7 September, 2021 by Samuelsson

Ever wondered what the mood in the market is? Of course, we know that emotions fuel the financial markets, but is there a way of knowing the prevailing emotion at every moment, and can that help in making trading decisions? In essence, you want to know about sentiment in trading.

In financial trading, market sentiment refers to the mood of the market, which captures the prevailing attitude of investors toward the market. Market sentiment is often manifested in the level of activity in the market and the associated price movement. Traders and investors use it to know what other market participants are feeling about that specific security to know how to trade the market.

To fully explain the concept of sentiment in trading, we will discuss the topic in detail under the following subheadings:

  • What is sentiment in trading?
  • Understanding sentiment in trading
  • How to use sentiment analysis in trading
  • What is a sentiment indicator?
  • How do you use sentiment indicators?
  • Limitations/drawbacks of sentiment indicators
  • The difference between sentiment indicators and technical indicators

What is sentiment in trading?

In trading, market sentiment describes the general view and perception of investors about that particular financial asset. It shows the feeling that dominates the market or the prevailing crowd psychology in the market.

Sentiment in any market can be seen in the level of activity in that market (more transactions with high trading volume), as well as in the price movement. For example, when the prices are on a continued rise, we can say there’s a bullish sentiment, while falling prices indicate bearish market sentiment. In the futures market, you can also use open interest to estimate market sentiment, in addition to price movement and transaction volume.

Traders can study the level of market sentiment and use that knowledge to decide whether to buy or sell the security. While some may want to trade in the direction of the sentiment, contrarians may want to go the opposite direction.

Understanding sentiment in trading

Whether you trade stocks, foreign exchange, or any other financial security, you would need to understand the idea of market sentiment. When you understand sentiment analysis, you can easily ascertain whether traders are feeling optimistic or pessimistic about the future price behavior of financial assets.

The tricky part of market sentiment is that everyone does not feel the same way about the financial market. Every trader in the market has their personal opinion of why the market performs the way it is and where the price action is heading next.

Amidst the opinions of the various participants in the market, the majority’s opinion often reveals the overall sentiment toward a financial market. But there is often a minority who have a contrary idea regarding the market. These contrarians would instead trade in the opposite direction of the prevailing sentiment.

Overall, sentiment analysis is a method of assessing traders’ commitment and opinion about the market to know how it can affect future price movement. If there’s a growing bullish sentiment, the market is likely to keep going higher, but up to a certain point. When there’s too much bullish sentiment — almost everyone is bullish — there will not be enough remaining bulls to push the market further up. The exact opposite is also true for bearish sentiment.

Do not confuse the sentiment analysis with fundamental or technical analysis. While fundamental analysis is concerned with business performance and technical analysis is about using historical market data to predict future price movement, sentiment analysis tries to know the direction the majority of the market participants are leaning towards, irrespective of how they arrived at their decisions.

How to measure market sentiment

Since investor sentiment or market sentiment is the aggregate attitude in the financial market, we want to find a way to quantify or measure the market attitude. However, attitude or sentiment is a qualitative variable and cannot be easily measurable. We can only characterize it as bearish, bullish, or somewhere in the middle.

For example, in stocks and options trading, we may try to characterize market sentiment by considering the volume traded with the direction of price movement. If the stock price is rising while the volume is falling, it can be deduced that the market is overbought, which means that the market sentiment may be about to change from bearish to bullish.

However, for decentralized financial markets like forex, the volume cannot be quantified. To measure market sentiment on your specific security, you can consider the market statistics. Some indicators can be used to determine investor confidence. Measuring participants’ confidence can help you determine if either fear is pervasive or greed is too high. There are a few indicators you can use to determine crowd psychology and get an idea of the level of bullishness or bearishness in the market.

Sentiment index: meaning (daily sentiment index)

The sentiment index is a popular and widely accepted way of determining the balance of power between the bulls and bears in the market. The Index is based on transaction flow information and is designed to show the ratio of long and short positions in the market. It can be categorized into the bullish sentiment index and bearish sentiment index. The bullish sentiment index is the ratio of the number of long positions to the total number of long and short positions, while the bearish sentiment index is the ratio of the number of short positions to the total number of long and short positions.

The sentiment index is based on the theory of contrary opinion, which claims that if most traders agree on the direction of a market move, then the odds are significant that prices will move in the opposite direction. The signs of a reversal are most potent when the balance of opinion is strongly skewed in one direction.

It was in 1987 that the idea of the daily sentiment index was launched. A numerical ranking system is employed to help traders get the most out of the index. Extreme bullishness is represented by any ranking approaching -10, which indicates a potential downward change in the market’s direction. Extreme bearishness would be any number close to +10, which would signal that the market is about to change in a positive direction, with the bulls taking control.

How to use sentiment analysis in trading

Sentiment analysis can improve your trading. You can use it to gauge how traders feel about the different markets in general or specific assets. Sentiment analysis can show how traders feel about taking risks. When traders are in the mood for more risk, they may generally pursue higher-yielding assets, such as stocks, since they may feel confident about chasing higher returns. However, when traders are not in the mood to take risks, they may put their money in safe-haven assets.

Market sentiment equities

While people drive the market, the people are driven by emotions. In the equity market, sentiment may influence stock prices more than any other factors — fundamental or technical factors. Sentiment analysis can help a trader ascertain investors’ general opinion on a particular stock or the market in general. The market sentiment in a specific stock can act as a forecasting tool and a pointer to its future price action.

For example, some emotional events, such as negative comments and opinions on social media about particular equity, may cause fear in the market and push investors to sell specific equity aggressively. Interestingly, the reverse can be the case when there is a generally positive attitude towards equity. This initial rush to buy or sell equity following its general market sentiment can create massive price movements in either direction, as was seen in GameStop stock (GME) in January 2021.

Market sentiment Forex: What is sentiment analysis in forex trading?

Although market sentiment can be used for stocks and other assets, it finds its primary application in the foreign exchange (Forex) market. In forex trading, sentiment analysis helps you better understand the price behavior and have a more profound knowledge of what other traders feel about a particular currency pair.

Market sentiment determines the mood in the market — bullish or bearish — and could, in turn, influence the market direction. Hence, you have to continually gauge the psychological and emotional attitude of all market participants.

Sentiment analysis in forex trading can help you know the prevailing trading decision in the market — whether most traders are going short or long. This can help contrarian investors understand when to open a trading position in the opposite direction to the prevailing market sentiment.

Market sentiment futures

A strong market sentiment exists in the futures market. For this market, open interest is a major factor in determining sentiment, in addition to the number of transactions and trading volume. Commodities with low open interest growth, high volatilities, low momentum, or low futures basis are more sensitive to change in sentiment.

For instance, commodity futures with high open interest growth, high volatilities, low momentum, or high futures basis are likely to earn higher returns during periods of bullish sentiment.

What is a sentiment indicator?

Sentiment analysis is a form of analysis that helps traders to ascertain if the prevailing market emotion is bullish or bearish. There are tools traders can use to estimate market sentiments. They are called sentiment indicators.

A sentiment indicator shows how a group of traders feel about the market or economy. Such tools are based on crowd psychology and aim at estimating the market sentiment using figures or graphs that predict how the general beliefs in the market may determine future market behavior. Many of them are gotten from surveying the feelings and attitudes of traders towards an economy or financial market.

What do sentiment indicators tell you?

Sentiment indicators can help tell you the level of bullishness or bearishness in the market. They indirectly show how the participants in the market are feeling, indicating the level of optimism or pessimism about the current market or economic conditions. A high reading might mean that investors are upbeat. Yet, from a high reading, some feel it may be about to head lower.

So, when sentiment readings are unusually high or low, it could give a reversal indication. For example, when investors are highly bearish, that is often a reversal signal that market prices could start heading higher soon. On the other hand, the sentiment is extremely bullish, it could indicate a potential reversal to the downside. This is primarily due to the overbought and oversold conditions that occur when the sentiment readings get either overly high or low.

Basically, sentiment indicators can increase the usefulness of your technical or fundamental analysis by giving you insights into the underlying strength of market movements.

What are the common types of sentiment indicators?

There are many types of sentiment indicators. They are designed to inform a trader of an imminent reversal owing to an extreme sentiment reading but may also be used to confirm a current trend.  Please note that sentiment indicators do not provide buy or sell signals; however, they allow traders to gain insights into the prevailing mood in the market.

Here are some of the common indicators analyst use to estimate market sentiments:

CBOE Volatility Index (VIX)

Dubbed the fear index, CBOE Volatility Index (VIX) is a common type of sentiment indicator that was launched in 1993. The indicator measures implied volatility, which expresses the expectations of the market participants about the future direction of the market. The indicator spikes whenever investors purchase a significant amount of put options to protect their portfolios, which shows that they expect the price of the underlying stock to fall in the near future.

Odd-Lot Trading Statistics

The trading strategy that is utilized here is taking a trading position in the opposite direction of odd-lot trading. It is assumed that retail investors mostly buy odd-lots when the bullish sentiment peaks and sells at the bearish sentiment’s climax. Therefore, whenever statistics report an increase in odd-lot trading, smart traders would want to open a trading position in the opposite direction.

The Commitment of Traders Report

The commitment of traders report is a weekly report that reveals the average trading positions of various traders in the futures markets. A rising speculative position indicates a rise in that asset’s price. However, an extreme surge in speculative interest could suggest that price reversal is imminent.

Market breadth indicators

These are indicators that check the performance of the overall market. They determine if a market is more likely to rise or fall by evaluating the strength of a bullish or bearish trend. Generally, breadth indicators do not provide trade signals on their own but rather give an overall picture of the market. This means that if, for instance, the breadth indicator and the broad stock market index, such as the S&P 500 Index, are rising simultaneously, it shows the price rise is substantial and is very likely to sustain itself.

There are various types of breadth indicators. Some of the common ones include the following:

Advance/Decline Line

This is one of the simplest types of breadth indicators and is based on the number of stocks that are advancing versus the ones declining. It is calculated by adding or subtracting the net advances — the number of advancing stocks minus the number of declining stocks — from the previous value.

High/Low Indicator

This is a simple sentiment indicator that is derived by dividing the number of securities in a stock exchange that are reaching 52-week highs by the number reaching 52-week lows. The High/Low Indicator offers an easy way to gauge market sentiment: the higher the number of issues reaching a new 52-week high, the more bullish markets will tend to be. When there are spikes in either direction, it denotes that an extreme bullish or bearish sentiment.

On Balance Volume of the broad market index

This is a type of breadth indicator that is calculated by either adding or subtracting volume depending on whether a stock or index closed above or below the previous closing price.

Arms Index (TRIN)

The Arms Index is a breadth indicator that is evaluated by dividing the ratio of advancing to declining stocks by the ratio of advancing to declining volume.

Up/Down Volume Ratio

This can easily be calculated by dividing the volume of rising stock by falling stock volume.

Up/Down Volume Spread

This is one of the most straightforward breadth indicators to calculate; you can get the Up/Down Volume Spread value by subtracting the down volume from the up volume.

How do you use sentiment indicators?

As we stated earlier, sentiment indicators help you to ascertain how bullish or bearish the market participants are at the moment. However, whatever you decide with that information is up to you. You may choose to be bullish when the indicators are bullish and bearish when they are bearish, or you may take the contrarian side. It’s your experience with the indicators that would tell you how to interpret them correctly in different situations.

Generally, when sentiment readings are unusually high or low, they may signal a potential reversal. But how high is “unusually high?” that is where your experience in using those indicators comes in. Let’s illustrate with a little example in currency trading:

Assuming there only 50 traders trading the EUR/USD: 30 (60%) of them are long and 20 (40%) are short. You may feel that there is a healthy bullish sentiment and go in the direction of the bulls. But if your indicator is showing that 45 traders out of the 50 (90%) are already long, you may figure that there are not enough traders that can come in later to push the price higher, so you might want to take the contrarian position and interpret that as a reversal signal.

As a rule, sentiment indicators become very useful when they are showing extreme levels. In that situation, the market may have been overbought or oversold, and a reversal becomes more likely than a continuation.

To get a better picture, you may combine with candlestick patterns to know if the price action is showing signs of a potential reversal. A reversal candlestick pattern, such as the hammer or shooting star, engulfing patterns, morning or evening star, tweezers, and others, can help you in this situation.

Limitations/drawbacks of sentiment indicators

Although sentiment indicators are essential tools in trading, they come with some drawbacks. As such, they should be combined with other forms of analysis to get the best results. Some of the limitations of the sentiment indicators include:

·         Sentiment indicators do not have a way of timing when the signals would occur: For instance, an extreme reading on the Commitment of Traders report does not necessarily mean that the asset’s price will immediately reverse. In fact, in some cases, an extreme reading can remain in place for a long time, or the price may stay where it is while traders unwind their positions and the extreme reading disappears without a significant price reversal.

·         Sentiment indicators cannot be used as a standalone indicator: Sentiment indicators are best used in conjunction with other technical and fundamental analysis forms to help confirm market or economic turning points.

·         Sentiment indicators are not used for confirmation of reversals: Sentiment indicators are an indication of how traders are feeling about a financial asset. So they can only be used as an early warning system and not to confirm new trends or reversals.

The difference between sentiment indicators and technical indicators

Most times, sentiment indicators are confused with technical indicators. Although they share a similarity, there is a subtle difference between the two forms of analysis.

While the sentiment analysis is designed to reveal how consumers or investors have positioned themselves or their current beliefs about the economy or market, technical analysis uses past price action to explain what is happening on a price/volume chart at the moment and what might happen in the future.

Final words

Overall, sentiment analysis plays a vital role in trading. It uses crowd psychology to determine the mood of the market, thereby giving a clue about which direction to trade. Sentiment indicators are used in gauging the market sentiment and where it is headed, whether it would continue or reverse. However, these indicators should be used alongside technical and fundamental analysis to provide a clearer picture of the markets.

 

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