What is market sentiment and how do you trade it?

As the value investor Benjamin Graham put it, in the short run the market is a voting machine, but in the long run it is a weighing machine. In other words, prices in the short term are driven by how people feel, and only settle towards fundamental value over time.

How do you feel about financial markets, do you think they'll rise or fall? If you can answer that, you already understand what your personal sentiment towards markets is, whether you trade shares, forex or another security.

Financial markets are fuelled by emotion, and this is one of the main reasons traders can find opportunities. Take stocks: one of the key reasons a share price doesn't necessarily match a 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 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 sentiment is only worthwhile if you can use it to get ahead of the game and make trades before the rest of the market. There's a big difference between how the market feels now and how it feels about the future, and only the latter provides a trading opportunity. In simple terms, you have to use 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. 

What is market sentiment?

Market sentiment represents the mood of financial markets and the general feeling among traders. Understanding it allows you to judge whether a market is feeling optimistic or pessimistic about the future price of a security, such as a stock or currency.

If the market is feeling positive about the outlook, this is referred to as a bull market; a pessimistic market that expects prices to fall is referred to as a bear market. Gauging sentiment, however, is tricky. The attitudes and outlook of a market are shaped by anything and everything, so investors need to spread a wide net to be as informed as possible.

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's heading. There are also contrarian investors who deliberately bet against the dominating sentiment. When the market is optimistic, a contrarian will take a pessimistic view.

Sentiment is demonstrated through price movements. If prices are rising, this is indicative of a bullish market, whereas prices declining point towards bearish sentiment. Sentiment differs depending on the market, and in some cases markets correlate with one another. Take safe havens like gold. When equities decline, the gold price often rises as investors look to plough their money into an asset that can hold its value, before reversing when equities pick back up. A large part of using sentiment to trade is being able to read when a market is about to turn, which is where fear and greed come in.

Trading emotions: fear and greed

The dominant feeling in the market usually dictates its overall sentiment. 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, so you avoid buying in when a price has topped out and faces a downturn (greed), or selling out when a price is bottoming just before it begins to rise again (fear).

For example, if sterling had been trading between $1.30 and $1.34 over a month-long period and then began rising significantly above $1.34, it could suggest greed has entered the market as positive sentiment snowballs. Unless there's a 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, may fall back to the range it was accustomed to. Fear works in the same way but can evoke more knee-jerk reactions, as investors tend to be more concerned about losing money than missing out on making it.

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

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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 towards rising or falling interest. If a company's share price has continued to rise but volumes begin to drop off, this could be indicative of weakening sentiment. It's worth remembering that it's harder to measure volumes for forex, because it's traded over the counter (OTC) rather than through a centralised exchange, making data on trading volumes less reliable.

With us, one of the most direct ways to gauge sentiment is our client sentiment tool, which shows the percentage of IG clients currently long versus short on a given market. Combined with the other indicators below, it gives you a real-time read on positioning that you can factor into your own analysis. For more on the tools available, see our trading platforms guide.

Market sentiment indicators

Market sentiment indicators are among the most helpful tools for judging how the market feels now and where it's headed, helping to find undervalued or overvalued opportunities. However, they should be used alongside other technical and fundamental analysis rather than as a single authority on the outlook.

Some of the most widely used indicators are:

Commitment of Traders (COT): published weekly every Friday by the US Commodity Futures Trading Commission (CFTC), the COT shows the net long and short positions of speculative and commercial traders. It outlines how the biggest traders, like hedge funds, banks and corporations, are positioned in futures and options, showing how committed they are to current trends. If the COT shows major traders have shifted to a more bearish attitude in what has been a bull market, this could point towards an upcoming turn. With forex traded OTC, futures are used as a proxy for the mood in currency markets.

Volatility Index (VIX): also known as the 'fear index', the VIX tracks options prices and measures implied volatility, making it useful compared with tools focused on present or historic sentiment. Option prices are a way for investors to protect themselves against a potential correction, almost like an insurance policy. The higher the implied volatility, the higher the fear that the current trend is about to snap; 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 or bearish mood. It compares how many stocks are heading to their highest level over the previous 52 weeks against those making 52-week lows. If the average direction is towards the lows, the bears are in control; when closer to the highs, the bulls are in charge.

Bullish percentage index: a clear-cut way of finding out how bullish the market is. It uses point and figure (P&F) buy signals, listing the number of stocks within a given index that have generated a buy signal, presented as a percentage between 0% and 100%. Generally, if 70% to 80% of stocks have buy signals, investors consider the market overbought and ready for a downturn, while a reading below 30% or 20% suggests it's oversold and potentially ready to rise.

Stocks above/below moving averages: the percentage of stocks above or below key moving averages (for example the 50-, 100- and 200-day) can help indicate whether the market is ripe for a rally or a drop. This can be used counter-intuitively: having more than 70% of the index above its 200-day moving average is a positive sign, but it also indicates much of the upward move has been completed. Finding times when only a small percentage of the index is above the 50-day moving average can often indicate dips within a broader uptrend that provide entry points.

Put/call ratio: this measures the number of put options (which expect the price to fall) divided by the number of call options (which expect it to rise). When the ratio falls below 1, more call options are being placed, suggesting more investors expect a bounce. A value above 1 indicates more investors think the market may slow or fall. Like the previous indicator, it's best used to identify possible bottoms, since readings can stay elevated for extended periods.

Track sentiment as part of your wider analysis

There are numerous ways to measure market sentiment and get ahead of the market before big moves occur. Tracking sentiment alone isn't enough to form the basis of a trading strategy, but it can be a useful addition to add depth to your analysis of where markets are heading.

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

Ready to trade on market sentiment? Open a live account to access our client sentiment tools across 15,000+ markets, or practise on a demo account with £10,000 in virtual funds first. For more, see our guides on technical vs fundamental analysis and the VIX.