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What is market sentiment and how do you trade it?

Understanding market sentiment can be a powerful tool for investors. Reading the mood of where the market is heading can allow you to capitalise from the changing direction. So, what is market sentiment and how do you trade it?

Chart Source: Bloomberg

‘In the short run the market is a voting machine, but in the long run it is a weighing machine,’ – Benjamin Graham, renowned investor regarded as the father of value investing.

How do you feel about financial markets – do you think they will rise or fall in the future? If you can answer that question, then you already understand what your personal sentiment is toward financial markets, whether you trade stocks, foreign exchange or another security.

Financial markets are fuelled by emotion and this is one of the main reasons investors can find opportunities to trade. Take stocks for example, one of the key reasons share prices do not necessarily match the company’s book value is because investors are reading beyond the fundamentals of the business and pricing in their sentiment, which can be influenced by all manner of things.

This shows the importance and impact of sentiment on markets, but also highlights the need to blend it with other measures such as technical analysis or fundamental analysis.

Understanding market sentiment is one thing, but trading it is another. Evaluating market sentiment as part of your trading strategy is only worthwhile if you can use it to get ahead of the game and can make trades before the rest of the market. There is a big difference to how the market feels now and how it feels about the future, and only the latter provides investors with a trading opportunity. In simple terms, you have to use market sentiment to identify trends and join the bandwagon before it’s too late and you’re left trading securities as they top or bottom-out.

So, how do you track the sentiment toward markets and how do you trade it?

What is market sentiment?

Market sentiment represents the mood of financial markets and the general feeling among traders, whether they trade foreign exchange, the stock market or anything else. Understanding sentiment allows you to judge whether a market is feeling optimistic or pessimistic about the future of prices of a security, such as a stock or currency, for example.

If the market is feeling positive and optimistic about the outlook then this is referred to as bull market, and a pessimistic market that expects prices to fall is referred to as a bear market.

Gauging market sentiment, however, is tricky. Attitudes and the outlook of a market are both shaped by anything and everything, therefore investors need to spread a wide net to ensure they are informed as much as possible about the ever-evolving market they trade.

In addition, while the majority of the market will lean one way or another, every participant holds their own view on why the market is performing the way it is and where it is heading next. While the opinion of the majority often dictates the overall sentiment toward a market, there are the likes of contrarian investors who bet against the dominating sentiment – when the market is optimistic a contrarian will take a pessimistic view, for example.

Market sentiment is demonstrated through price movements of the security in question. If prices are on the rise, then this is indicative of a bullish market. Whereas prices on the decline point toward bearish sentiment.

Sentiment will differ depending on the market, and in some cases often correlate with one another. When bullish sentiment starts to surface in one market, bearish sentiment can emerge in another, or vice-versa.

Take safe-havens as an example, like gold. When equities are on the decline the price of gold is often on the rise, as investors look to plough their money into a commodity that can hold its value, rather than risking their capital on uncertain stock markets, before reversing when equities pick back-up as money shifts from one to the other. A large part of using market sentiment to trade is being able to read when a market is about to turn, which is where fear and greed come into play.

Read more on commodities trading

Trading emotions: fear and greed

The dominant feeling in the market usually dictates the overall sentiment of a market. Most investors are conditioned to follow the general direction of prices, but eventually, the bullish or bearish mentality will peak. Understanding when that peak has arrived is important for investors so that they avoid buying-in when a price has hit its peak and faces a downturn (greed), or selling-out when a price is bottoming out just before it begins to rise again (fear).

Being able to spot any emergence of fear or greed is helpful in identifying those that are usually selling-up as prices hit the low of a price movement, and those that chase the crowd and buy just as the market heads lower.

For example, if sterling had been trading between $1.00 and $1.10 over a month-long period and then began rising significantly above $1.10, it could suggest greed has entered the market as positive sentiment snowballs. Unless there is good reason for sterling to have broken through a new high, the drive upward is likely to have been spurred on by emotion and, eventually, will fall back down to the $1.00-$1.10 range it was accustomed to. Fear works in the same way but can evoke more knee-jerk reactions from investors, which tend to be more concerned about losing money than missing out on opportunities to make money.

To summarise, fear and greed can catch out investors and see them buy over-priced securities or selling securities for a loss, or less profit than was possible. Spotting when fear or greed has taken over, however, presents investors with an opportunity as they can then identify when the market is about to turn.

How to trade market sentiment

Volume can be one way to evaluate how markets are feeling. This is particularly true for stocks and options as it can point toward rising or falling interest. If a company’s share price has continued to rise but volumes begin to drop-off, for example, then this could be indicative of weakening sentiment. In this context, it is important to remember that it is harder to measure volumes for forex because it is traded over-the-counter (OTC) rather than through a centralised market like a stock exchange, making data on items like trading volumes less reliable and harder to gauge.

Learn more about forex trading

Market sentiment indicators

Market sentiment indicators are one of the most helpful tools at the disposal of investors looking to judge how the market feels now and where sentiment is headed, helping to find undervalued or overvalued opportunities. However, these indicators should be used alongside other technical and fundamental analysis to provide added depth to research, rather than used as a single authority on the outlook for financial markets.

Learn more about using psychological indicators to assess risk to reward

Some of the most widely used indicators and tools used by investors to pinpoint sentiment are:

Commitment of Traders (COT): The COT is published by the Commodity Futures Trading Commission (CFTC) on a weekly basis every Friday and shows the net long and short positions of speculative and commercial traders. This helps outline the market dynamics by detailing how the biggest traders (like hedge funds, banks and corporations) are positioned in terms of futures and options, showing how committed they are to the current trends. If the COT shows major traders have shifted to a more bearish attitude in what has so far been a bull market, then this could point toward an upcoming turn in the market. With forex traded OTC, futures are used as a proxy to gain an idea of the mood in forex markets.

Volatility Index (VIX): Also known as the ‘fear index’, the VIX tracks options prices and measures implied volatility – making it a useful tool compared to ones that focus more on the present or historic sentiment. Option prices are used as a way for an investor to protect themselves against any potential correction in prices, almost as an insurance policy. In this context, the higher the implied volatility the higher the fear that the current trend is about to snap. While low implied volatility suggests sentiment is stable and the current trend will continue.

High/low Sentiment Ratio: One of the easiest ways to find out whether the market is in a bullish mood, or a more bearish one, is the high/low sentiment indicator. This involves comparing how many stocks are heading to their highest level over the previous 52 weeks to the amount making 52-week lows. If the average direction of the market is toward the lows then the bears are in control, and when the market is closer to the highs the bulls are in charge.

Learn more about indices trading

Bullish Percentage Index: This index is a clear-cut way of finding out how bullish the market is. The index uses point and figure buy signals, listing the amount of stocks within a given index that have generated a buy signal. Under point and figure (P&F), stocks either carry a buy or sell signal to make it a very clear and unambiguous measurement of sentiment. The reading is presented as a percentage between 0% and 100%. Investors apply their own thresholds to this index to determine whether the market is over or undersold, but generally if 70% to 80% of stocks have buy signals then investors consider the market to be over-bought and ready for a downturn. While a reading below 30% or 20% would suggest the market is oversold and potentially ready to rise.

Stocks above/below moving averages: Moving averages help identify when a market could be about to break higher or lower. The percentage of stocks above or below key moving averages (for example the 50-, 100- and 200-day), say on the New York Stock Exchange (NYSE) for example, can help indicate whether the market is ripe for a rally or a drop. This can be used counter-intuitively, since having more than 70% of the index above its 200-day moving average is possibly a positive sign, it also indicates that much of the upward move has been completed. Instead, finding times when only a small percentage of the index is above the 50-day moving average, for example, can often be used to indicate dips within a broader uptrend that can provide entry points.

Read more on moving average trading strategies

Put/call ratio: This measures the number of put options (which expect the price to go down) divided by the number of call options (which expect the price to rise). When the ratio falls below 1, this indicates that more call options are being placed, suggesting that more investors expect a bounce. Conversely, a ratio value above 1 will indicate more investors think the market may start to slow or fall. Like the previous indicator, the tool is best used to identify possible bottoms, since we can have elevated readings on both for extended periods of time on the upside.

Conclusion: track market sentiment as part of your wider analysis

To summarise, there are numerous ways to measure market sentiment and get ahead of the market before big moves occur. Tracking sentiment alone is not enough to form the basis of a trading strategy but can be a useful addition to help add depth to an investor’s analysis of where markets are heading.

Read more on the basics of technical analysis

Market sentiment should not be underestimated – people and their perception is what drives markets higher or lower. News and developments are never-ending in financial markets; investors should try to take in as much as possible and listen to both the bulls and the bears to gain as complete a picture of the psychology of the market as possible and, more importantly, where it could be going next.

Find out more about the markets you can trade with IG

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