A guide to market sentiment: what is it, indicators and how to trade it

Market sentiment is one of the most popular ways of analysing trending markets and whether a stock is over or undervalued. Find out what market sentiment is and how it can be used in a trading strategy.

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What is market sentiment?

Market sentiment is the collective attitude of investors and other participants in financial markets. It describes the outlook that the market has as a whole about where prices could move in the future. When prices rise, it indicates that there is a bullish market sentiment, making it likely the trend will continue, while falling prices indicate bearish market sentiment.

Market sentiment isn’t necessarily based on fundamentals, but rather investor attitudes. This is why market sentiment is often viewed as a more psychological phenomenon. It’s likened to crowd mentality, in which people get swept along with the prevailing trend rather than using their individual opinions. This is where emotions tend to come into trading, such as fear and greed.

For example, let’s say bitcoin is increasing in value. Investors who already hold bitcoin see their holding increase in value, which then leads others – often novice traders – to want to enter the market so they don’t miss out on the profits. As the demand for bitcoin increases, the bullish sentiment causes the price to rise even further. Eventually, the market price would reach a level so high that investors are unwilling to sustain it, and they’d exit their positions – leading to a bearish run on bitcoin.

Investor sentiment in the stock market

Investor sentiment in the stock market is the collective judgment of future price patterns for an individual company’s shares and/or the stock market as a whole. Market sentiment in the stock market is one of the easiest to measure, as the volume of interest in a particular stock is measured each day and reported by exchanges.

Market sentiment is actually a popular indicator in itself for finding over and under-valued stocks. By understanding whether share prices are trading above or below their intrinsic value, speculators can take advantage of the movement and also capitalise on a reversal back toward a more accurate price.

A change in sentiment in one market often leads to a change in another. For example, when equities decline in value, safe-haven assets – like gold, silver and the Japanese Yen – typically rise in price. So, sentiment is a useful factor to consider when starting a hedging strategy, as you’ll be able to find correlations that can offset risk from one position to another.

Forex market sentiment

Forex market sentiment is the measurement of how many trades or traders have a particular view of a country’s currency. As currencies are quoted in pairs, a single position will express both a bullish and bearish sentiment. For example, you’d take a long position on GBP/USD if you had a positive outlook on the British Pound and a negative outlook on the US dollar in comparison.

Forex is traded over the counter (OTC), which means reporting for volume is less reliable. This can make it more difficult to get data on the interest in a currency pair at any given time.

How to read market sentiment

Reading market sentiment is difficult because it’s nearly impossible to accurately measure opinions and individual psychology. However, there are a few technical indicators that can be used to gather data on which direction prices are moving in, especially when they reach extremes that suggest emotional trading is at play.  

Reading market sentiment indicators enables you to assess whether a particular asset is trading in line with expectations or whether it’s trading above or below its intrinsic value.

As mentioned, the most useful indicators for sentiment will vary depending on whether the asset is exchange traded or OTC, due to differences in availability and reliability of data.

Volume

Volume is the most common way of identifying how market participants are feeling. Although volume data doesn’t indicate which direction a market is moving in, it can give us information about how much interest there is.

For example, if we look at volume data for a particular company’s shares and see that the price is continuing to rise but volume is falling, this could indicate market sentiment is waning.

Volume is only really used for exchanged-traded assets – such as shares, options, commodities and futures – as these centralised institutions record all trades, whereas over-the-counter (OTC) markets don’t necessarily have reliable trade data.

Commitment of traders (COT)

The Commitment of Traders is probably the next most used market sentiment indicators, particularly because it’s one of the only ones that can be used for assessing the forex market. The COT report includes data about all the transactions – both long and short – in the forex market as well as commodities markets, options, futures and other derivatives.

The report is released every Friday by the Commodities Futures Trading Commission (CFTC). It details all the overall interest in the markets by three groups of traders – commercial, non-commercial and non-reportable (speculators).

By understating what positions other traders are taking, you can make judgements about the market trend and build your own trading strategy.

The Volatility Index (VIX)

The Volatility Index (VIX), also known as the fear gauge, tracks implied volatility on the S&P 500. It does so by using options prices to assess what investors are willing to pay for the S&P in the near-term.

The higher the VIX, means the more the market fears the current trend is about to reverse. Meanwhile, low implied volatility suggests that market sentiment is continuing in its current vein.

High/low sentiment index

The high-low index looks at the number of stocks making 52-week highs and compares that to the number of stocks making 52-week lows. It’s used to judge whether stocks and indices are (on the whole) rising or falling and can also gauge the movement’s strength. The high/low index is usually applied to specific global indices, such as the S&P 500 and Nasdaq 100.

When the index is below 30, it indicates that stock prices are trading near their lows, and there’s a bearish market sentiment. When the index is above 70, stock prices are trading around their highs, and there’s a bullish market sentiment.

How do you trade with market sentiment?

You can trade market sentiment in a few quick steps:

  1. Open an account with FOREX.com or log in to an existing account
  2. Choose a market (or markets) to trade
  3. Identify the direction of market sentiment using analysis
  4. Take a position on whether the market will rise or fall
  5. Monitor changes in sentiment and close your position

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