Using psychological indicators to assess risk to reward

Traders can use various psychological indicators as a part of the process of identifying opportunity and the trade’s risk-to-reward assessment. As well as a general understanding of broad sentiment in a market.

Market data
Source: Bloomberg

In the same vein as technical indicators such as a MACD (moving average convergence/divergence) or RSI (relative strength indicator), having a real understanding of how you can correctly utilise these indicators, as part of a structured trading plan, can often increase the probability of a positive trading outcome. It can really help shape a positive expectancy, which is so important if one is to thrive longer-term as a trader.

Understanding market sentiment

In principle, the study of psychological indicators, specifically when used to trade an equity index (such as the US 500, Australia 200 or Germany 30), can include a broad and diverse range of indicators. Most commonly traders will look at the put/call ratio, implied volatility (such the “VIX” or US volatility index), the level of margin debt and the net futures positioning (many will look at the weekly ‘Commitment of Traders’ report compiled by the CFTC), specifically held by the leveraged/speculative trading community.

These can be really useful tools to understand sentiment, where after a strong move in a market, we will often see extreme greed (or euphoric) or pessimistic conditions portrayed in the chart of that indicator, certainly when viewed in the context of the long-term trend. In this situation and when positioning has become extreme, the reward (part of the risk/reward equation) becomes less attractive and we often see reversals. It is important to understand actually what constitutes ‘extreme’.

The study of a markets internals

Traders can also focus on a market ‘internal’ positioning. Again, these can include a vast range of different variables, in which a trader will often use a combination to make a more comprehensive assessment on the risk-to-reward trade-off around an opportunity. These may include looking at the percentage of companies (in an index) trading at four- or 52-week highs, or the percentage of companies trading above their 20-, 50-day or 200-day moving average. One can even look at the percentage of companies trading above their upper Bollinger Band, or that have an RSI greater than 70, or lower than 30. 

One idea here is that traders are not just looking at how a market goes from A to B, but they also want clarity as to what stage the market could be within that journey. They are also interested in the perceived quality of that journey and whether the move has been caused by a handful of companies with sizeable market weightings, or whether the gains (or losses) were broad-based. This is why many refer to ‘market breadth’ as a tool to use to assess sentiment.

It is seen as a positive when a market rallies with strong participation from the members of the index.

So importantly, these indicators can provide real colour in the assessment of both the underlying strength of a market move, but also whether current conditions have perhaps gone a bit too far.

As mentioned above, traditionally, one would think of an equity index (or corresponding futures market) when using these indicators. Naturally, here we think of the number of constituents or companies that make-up that index, which of course is simply a valuation tool, determined either by the company’s market capitalisation or price. There are, however, certain indicators which can also be really good to use when trading FX, bonds and commodities. These can really tell us a lot about sentiment and with it, timing a market reversal.

One such indicator would again be the weekly ‘Commitment of Traders’. For context, every Tuesday various futures players (including hedge funds) report their gross long and short positions to the CFTC, who aggregate this into one net market position and detail this to the world late on Friday (early Saturday for us in Australia). Again, traders would assess if the market has increased its exposure too greatly in one direction.

The most important aspect of using these indicators

Perhaps the most critical point of using psychological-based indicators is rather than just simply taking an opposing position to the trend, because the market's position has become too one-sided. The higher probability outcome here is to combine the use of these psychological indicators, with a technical overlay and more preferably assessing price action and when the reversal is playing out. By adding an assessment of price action we can get conviction that either the trend is likely to continue, or a genuine reversal is in play. So waiting for confirmation from the market often leads to a higher probability outcome, rather than simply positioning in a market in anticipation.

Finding these indicators is fairly straightforward and while many will use a Bloomberg or Reuter’s terminal, there are many good websites that traders can access for free these days. I will touch on these in my Monday trading webinar too.

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