Market Sentiment Definition

Market sentiment refers to investors’ general feelings toward an asset in financial markets. The investors’ feelings directly impact the price of an asset in the market. In other words, when most people in a market feel good and optimistic about an asset, the related price trend of that asset will be bullish, and the prices start to rise. On the other hand, feeling pessimistic about an asset leads to a bearish price trend, and prices start to fall. To find out about a market’s current sentiment, investors can use some technical analysis tools.

Understanding market sentiment

As we pointed out, market sentiment is not just related to fundamental analysis. Since the market sentiment affects technical indicators, technical analysts use it to evaluate the market and make a good profit in short-term price fluctuations.

In general, market sentiment has only two states, bullish and bearish. When the number of bulls (optimistic investors) is more than bears (pessimistic investors), the price of assets will rise and vice versa. A group of investors in the market consistently look for undervalued or overvalued assets considering the market sentiment. To identify the market sentiment, they use some technical indicators such as Volatility Index (VIX), High-Low Index, moving averages, and Bullish Percent Index (BPI).

Market sentiment indicators

1) CBOE VIX Index

The Chicago Board Options Exchange (CBOE) is the creator of VIX. It is a real-time index and the first-ever benchmark to measure the market fluctuations in the future. VIX only shows the implied volatility of S&P500 for one month ahead. It uses SPX index options prices to show investors a percentage. When this percentage goes higher, the S&P500 will usually fall down, and when the VIX percentage dops down, the S&P500 will remain stable. Although it is designed to measure the S&P500 volatility, it is used by many investors to gauge to whole US market.

2) High-Low Index

This index tracks the latest 52-week highs and the latest 52-week lows between stocks in a prevailing index. Investors use this technical index to identify the upward or downward direction of a market in the future. The high-low index is a breadth indicator, and it can measure the strength or weakness of an index.

The main duty of a high-low index is to show whether an underlying is index is bullish is or bearish. When the percentage of that this index shows us is more than 50%, it tells us that there are more 52-week record highs than 52-week record lows. The opposite happens when the percentage is less than 50%. The underlying index is bullish when the percentage is consistently more than 70%. Also, when it is consistently less than 30%, the underlying index will be considered bearish.

3) Moving average

Moving average is a technical indicator that combines price points of an asset over a specified time frame, then divides them by the number of price points, and presents a trend line. The moving average helps investors identify the current price trend of an asset. Also, it helps you to find the support and resistance levels by analyzing the previous price movements. Therefore, the previous price action of an asset helps you specify possible future prices and patterns. The moving average has two primary forms, simple moving average (SMA) and exponential moving average (EMA). EMA gives more importance to the latest price points, but in SMA, the newness of data does not matter.

4) Bullish Percent Index

The bullish percent index is calculated using the chart patterns stocks in the index. If 80% of the index displays a bullish pattern, the market’s sentiment is deemed positive. However, when just 20% of an index is bullish, the market sentiment is bearish.

How to use market sentiment for our trades?

If you want to use market sentiment for your trades, you should use it in combination with other analysis tools to get the best results. Usually, investors find better trading opportunities when the market sentiment and fundamentals do not match each other. Keep in mind that when market sentiment indicators show extreme levels, you can expect a turning point in the current price trend of an asset. Sentiment has the power to change the supply and demand, even if it is against the fundamentals, especially in the short time frames.

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There are two important factors that every investor must consider when he makes decisions based on market sentiment. The first one is that price will keep rising or stay in a stable situation as long as market sentiment is positive. Negative sentiment will make the price drop or does not let it go higher. The second point is that a positive sentiment can lead to overbought or a bubble condition, and a sharp price drop always follows it. Also, the negative sentiment may lead to an oversold situation where the price of an asset becomes undervalued.

Conclusion

The market sentiment can help investors predict future trends. However, you should never rely on one type of technical analysis to make decisions based on it. It is always recommended to use a group of technical analysis tools to prevent false signals. To trade using market sentiment, you must first understand how sentiment changes and be aware of the fundamentals and trends.

As a trader, you must be aware of what could happen if sentiment shifts in any direction. Usually, when sentiment shifts quickly and a substantial number of market players switch from bullish to bearish or vice versa, the biggest price swings occur. Investors can spot great trading opportunities when the conditions lead to a quick change of sentiment.