Using a Market Sentiment Indicator to Develop Your Trading Strategy

M arket sentiment indicators give insight into the overall attitude of a market. Learning how to take what you see on an investor sentiment chart and transform it into a strategy is an important skill for any investor to have.

Key Takeaways:

  • Market sentiment indicators give a numerical or graphical indication of how a group feels about the market.
  • Sentiment indicators can give insight into how optimistic or pessimistic investors are at a given time, and they can help predict how behavior might change in the future.
  • Market sentiment indicators are not timing signals, so they are best used along with other technical and fundamental analysis tools to develop a trading strategy.

What Is a Market Sentiment Indicator?

Image via Unsplash by adamaszczos

A market sentiment indicator is a numerical or graphical indicator that shows you how a given group feels about the market. Sentiment indicators try to quantify how currently held beliefs and positions will affect behavior in the future.

A stock sentiment indicator can show how bearish or bullish a group of people are. This, in turn, can help to forecast that group’s future behavior — often in a contradictory way. When investors appear very bearish, for instance, that often gives a contrary signal to sentiment indicator traders that prices on the market could soon start rising.

What Is Market Sentiment?

Market sentiment refers to investors’ overall attitude toward a given financial market or security. The sentiment is the tone or feeling of a market, and it’s revealed through the price movement and activity of securities traded in that market. Generally speaking, when prices rise, it indicates bullish market sentiment, and when prices fall, it indicates bearish market sentiment.

Sentiment Indicators vs. Technical Indicators

Though some indicators can be both a sentiment indicator and a technical indicator, sentiment indicators and technical indicators are not the same thing. A sentiment indicator is used to show how investors or consumers have positioned themselves, or it shows the current belief of these investors or consumers about the market. A technical indicator is a broad term that’s used to describe volume or price data of an asset to give a different perspective on what you see on a volume or price chart.

What Do Market Sentiment Indicators Tell You?

Investors can use stock market sentiment indicators to figure out how optimistic (or pessimistic) people are about current market conditions. The data a sentiment chart shows is subject to interpretation.

While a high reading can show that consumers feel upbeat, some investors believe that means the indicator will likely go lower over time. Likewise, while a low reading can show that consumers are feeling downtrodden, it may also mean that things will improve soon.

Limitations to Using a Sentiment Indicator

As sentiment indicators offer just one piece of data, they are not used as timing signals for taking action. If a sentiment indicator has a very high reading, it shows that investors expect stock prices to decline, and the contrary aspect shows that prices will likely soon rise (as few people are left to continue to push prices down). The sentiment indicator does not show when changes will happen. Traders instead use the data to watch for price turning points when sentiment levels go to extremes.

Extreme readings can stay in place for long periods of time. Prices can also stay at the same level while traders unwind their positions, causing the extreme reading to disappear — without a big price reversal.

On the other hand, when a sentiment indicator isn’t near an extreme, it can help to confirm a current trend. For instance, a rising put/call ratio shows that investors are pessimistic, helping to confirm a downward price trend.

If you’re using a sentiment indicator, it’s best done in conjunction with other types of fundamental and technical analysis. This helps to confirm the turning points you see.

A very bullish sentiment reading together with a very high price/earnings ratio and a breakdown in prices (sometimes in addition to deteriorating fundamentals) gives you conclusive evidence that there’s an impending downtrend. Often, it gives you much more information than just looking at sentiment alone would.

Types of Market Sentiment Indicators

Here are some common types of sentiment indicators:

  • Accumulation/Distribution Line: This line measures cumulative money inflows and outflows in an asset. Accumulation is how much of an asset investors buy, while distribution is the amount of an asset that market participants sell. You can use this indicator to confirm a trend and/or measure the buying and selling pressure on an asset. Look at the direction of an asset along with the direction of the Accumulation/Distribution Line to find a trend confirmation signal.
  • Advance/Decline Ratio: You get this ratio by dividing advancing issues by declining issues. The oscillator can then give information about the market’s strength and breadth. Traders often look at a moving average to know about this indicator’s direction.
  • Bullish Percent Index (BPI): Using point and figure charts, the BPI measures the number of stocks that have bullish patterns. A bullish percentage around 50% signifies a neutral market. At 80% or higher, the market sentiment is very optimistic, and stocks are probably overbought. At 20% or lower, market sentiment is negative and the market is likely oversold.
  • CBOE Volatility Index (VIX): This indicator is also known as the ‘fear index’ as it spikes when investors buy a significant amount of put options. This is done to protect portfolios. Investors buying put options believe that the price of an underlying stock is going to fall, so a spike in the VIX often means there’s fear in the market.
  • The Commitment of Traders Report: This is a weekly report that shows aggregate positioning in the futures markets of various groups of traders. As the speculative position rises, it indicates rising price of that asset. However, when the speculative interest goes to an extreme, it may indicate that prices will go the other direction.
  • High/Low Indicators: This indicator helps investors compare stocks that are making new 52-week highs relative to stocks that are making new 52-week lows. If there are spikes in either direction, this tends to indicate extreme bearish or bullish sentiment. Contrarian investors can also use this indicator if they want to buy quality stocks during severely pessimistic periods. One commonly used indicator is the New York Stock Exchange (NYSE) High/Low Indicator.
  • Odd-Lot Trading Statistics: Odd lots are fewer than 100 shares for most stocks. The indicator measures the number of shares that are being bought and sold in those odd lots and works on the theory that retail investors (who typically have the least amount of money) are likely to buy and sell odd lots. The theory holds that these investors will buy when bullish sentiment peaks and sell when bearish sentiment does. As a result, savvy investors may take a position in the opposite direction when odd-lot trading rises during market extremes.
  • Moving Averages: Investors use both a 50-day simple moving average, or SMA, and a 200-day SMA to determine the sentiment of a market. Moving averages like the NYSE 200-day Moving Average give a reading about how many stocks are trading above the long-term moving average. The indicator is expressed as a percentage. A rising indicator that shows more than 60% of stocks trading above their 200-day moving averages, for example, shows a broad bullish sentiment. If the reading goes over 80%, it may mean the stocks are overbought.
    • A ‘golden cross’ happens when a 50-day SMA crosses above a 200-day SMA. This signifies that momentum has made a shift to the upside and indicates bullish sentiment.
    • A ‘death cross’ happens when a 50-day SMA crosses below a 200-day SMA. This signifies lower prices and generates bearish sentiment.
  • Put/Call Volume Ratio: This ratio compares the total number of puts to the total number of calls. You can use it to understand when buying or selling pressure of the market is at an extreme. A very high ratio shows that the market might be too bearish, and if sellers are in positions already, prices can’t go down further.
  • TRIN Index: This market sentiment index is also called the Arms Index and the Short-Term Trading Index. It is used to figure out the general market sentiment by measuring the relationship between supply and demand. You find the TRIN Index by dividing the advance/decline ratio with the up/down volume ratio. You can then compare this index with a stock market index to forecast market trends.
  • Additional Fear and Greed Indicators: There are numerous other indicators you can use, including:
    • Junk bond demand.
    • The McClellan Volume Summation Index.
    • Safe haven demand.

How to Use Sentiment Indexes

Many trading platforms will let you see market sentiment indicators so you can gauge the mood of the market. It’s up to the investor to decide how to incorporate the perception they get of the market from looking at a market sentiment index chart into developing a trading strategy and deciding on trades. Using a market sentiment chart and sentiment indicator analysis, you can:

  • Find indications about how weak or strong a movement might become.
  • Get a sense of the mood of investors by looking at trading volume and volatility.
  • Identify sentiment that has a strong upward or downward movement in the market.

When used in combination with other technical and fundamental analysis tools, market sentiment indicators can help you figure out the current mood of a market and how that might lead to future behavior. You can integrate your understanding of market sentiment indicators to develop a trading strategy that works for your goals.