When are you analyzing an asset (stock/option/currency) – Where do you put your focus on? One of the first things a trader has to think about when trading is what kind of analysis is most suitable for his/her trading goals.
Among the most common types of analyses are Technical Analysis and Fundamental Analysis. The first type of analysis uses price action to decide when to trade.
The second analysis type looks at a given company’s performances or global economic health and compares them to the intrinsic value of a financial asset, in order to decide whether the asset is under or over-valued.
However, investors often forget that there is another type of analysis at their disposal: Sentiment Analysis.
Sentiment Analysis allows you to evaluate market sentiment, which will help you get potential directional signals about where the asset/market you are evaluating may be heading. Most of the time, you will see that positive information about a given asset or the health of the global economy leads to long positions.
Negative information, on the other hand, will usually lead to short positions.
Note that this isn’t set in stone, however – you may have heard the phrase “good news is bad news” in reference to traditionally “bad” financial events that actually lead to price increases.
It’s all about market participants’ interpretation of the available data and its impact on the markets.
Identify Market Indicators
In many financial institutions, quants are more and more frequently using sentiment analysis to develop trading models. This helps them to better understand market participants’ psychology.
These trading models will also produce more accurate predictions and better results.
If you use Google Trends to check the popularity of sentiment analysis, you can see that sentiment analysis has been attracting more and more attention over the last few years. Retail traders also understand the importance of market sentiment in their trading decision process and want to know more about it.
Market Sentiment Formation
Markets could be seen as a network with individuals who are reacting to the news. Each trader has thoughts and opinions on a given asset that will be reflected in its position (long or short). Together, these positions will form the overall market sentiment, given the available information.
If you are the only one to see a bubble ready to burst on a given market, you wouldn’t be able to make the market move in your favor.
As a trader, you need to take all this into consideration. You can then use sentiment analysis to assess and understand:
- How investors think
- What the consensus about a given financial asset is
- What the expectations of the market participants are
- What news they follow the most
How To Use It?
Only then can you decide how you will incorporate the perception of the market you have in your trading strategy. Taking into account sentiment analysis, you will be able to:
- Get an indication of how weak or strong a movement could become
- Identify market sentiment with a strong upwards or downwards movement
- Know how nervous investors are by looking at volatility and trading volume
Many trading platforms will allow you to use sentiment market indicators to gauge the market’s mood. You can expect a reversal when these indicators are going too far in either direction. Let’s have a look at some of the most important sentiment market indicators.
Put/Call Volume Ratio
If you think that an asset will decrease in value, you could buy a put option. Conversely, you will buy a call option if you expect that the price of an underlying asset will increase. The Put/Call ratio is the ratio of the total number of puts to the total number of calls.
You can use it to know when the buying/selling pressure of the stock market is at an extreme.
A very high Put/Call ratio usually indicates that traders might be too bearish.
You can then conclude that if all the sellers are already in positions, then prices cannot be pushed any further down. Conversely, a high number indicates that the buying pressure might be too strong. If all buyers are already in positions, then prices cannot be pushed further up.
When these kinds of situations occur, you can reasonably expect a reversal to happen soon thereafter.
The Advance/Decline ratio divides the advancing issues by the declining issues. You can then use this oscillator to know more about the strength of a market. This indicator is also often used to highlight markets’ breadth.
You can then get clues about whether the market is oversold or overbought. Usually, a low ratio indicates an oversold market, while a high ratio indicates an overbought market.
New High/New Low Ratio
This technical indicator is very simple. It is the number of issues reaching 52-week highs divided by the number of issues reaching 52-week lows. You can use this indicator to gauge market sentiment.
For example, the higher the number of issues reaching a new 52-week high, the more bullish markets will tend to be.
In the same way, when you observe that the number of new high issues declines while markets are still going up, you can, therefore, conclude that only a few shares are pushing the index higher.
When an indicator and an asset do not evolve in the same direction, it’s called divergence. In our example, this divergence means that you can expect an upcoming decline in the index.
Accumulation refers to how much of an asset is bought by investors. Distribution, on the other hand, refers to the amount of the asset that is sold by market participants.
This line was thus created to measure the cumulative money inflows and outflows into an underlying asset. You can use it to measure the buying/selling pressure on an asset, as well as to confirm a trend.
In order to identify a trend confirmation signal, you should have a look at the direction of the asset and the direction of the Accumulation/Distribution line. A bullish A/D line trend confirmation occurs when the line increases with higher volumes.
Conversely, a bearish A/D line trend confirmation happens when the line decreases with higher volumes. When divergences happen, you can expect a potential reversal.
CBOE Volatility – The VIX Index
As explained in our article on Bollinger Bands, volatility represents the velocity or price changes of a market”. To measure volatility, you can either use historical volatility or implied volatility.
Historical volatility looks at the past, while implied volatility describes what the market sentiment suggests may happen. Implied volatility is often used to price options.
The VIX, often called the fear index, is based on options prices and is a volatility index. The Chicago Board Options Exchange gives the following definition of the VIX:“The CBOE Volatility Index is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
Since its introduction in 1993, the VIX Index has been considered by many to be the world's premier barometer of investor sentiment and market volatility”.
High VIX/Low VIX – What does it mean?
A rising VIX indicates that many traders want to hedge their portfolio against losses – so they will, therefore, buy put options.
A high VIX thus suggests that there are many uncertainties about the direction of the markets. The red rectangles on the below chart shows volatility spikes that correspond with important international events such as the financial crisis of 2007, the European debt crisis in 2010/2011, the Chinese Yuan devaluation in 2015, etc.
A low VIX will usually reflect investor complacency. Note that the VIX and the S&P 500 index often have a negative correlation, meaning that they tend to evolve in opposite directions.
Remember – It’s best to use market sentiment indicators as a part of your trading plan with other forms of analyses, such as technical analysis. Most traders first use sentiment analysis to know about the general direction of the market.
Then, they use technical analysis (mathematical indicators or chart patterns) to identify entry/exit points. All of this can help you to increase your success and your overall trading performances.
Useful Tools To Spot Indicators
Candlestick patterns are very useful tools to get a complete overview of market psychology. The opening and closing prices create the body of a candle. The wicks, or shadows, show the highest and lowest levels reached.
The size of the candle and the shadow thus reflects market psychology and the intensity of the movement. Therefore, a longer body suggests that the buying or the selling pressure is intense.
Be sure to have a look at our Technical Analysis section to get some further insights into the most powerful trading strategies. What are your favourite investment strategies? Which other market sentiment indicators do you use? Share your trading experience and leave a comment!
The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.