Market Sentiment in Trading
Market sentiment is meant to capture the intangible psychological effects that the feelings and attitudes of investors have on the price action of securities.
For example, a share price that rises rapidly as a result of some fundamental factor may also generate a corresponding sense of greed or fear, or both, in the market that results in price action beyond what the initial fundamental factor should cause.
Market sentiment attempts to account for the fact that investors are not perfectly rational by looking for patterns to how they trade emotionally, particularly during times of high volatility.
Traders who use market sentiment indicators believe that the emotional reactions of investors can be forecast using these indicators, and profitable trading opportunities created simply from trading on the greed and fear of other investors.
Market Sentiment Indicator Examples
There are a large number of market sentiment indicators used by traders, but many of them are merely small variations on a few core central themes.
• Volatility Index
A volatility index is a measure of option prices on securities in a market or sector that is purported to measure the degree of uncertainty toward that market or sector. A volatility index as a market sentiment indicator is based on the belief that the greater the increase in the premium that investors are willing to pay for the insurance that options offer, the greater the sense of uncertainty in a market.
• Bullish Percentage
The bullish percentage market sentiment indicator is a measure of the number of stocks showing bullish market patterns. In a neutral market, the bullish percentage should be in the range of 50%, while a bullish percentage above 80% indicates that the market is likely overbought and a bullish percentage below 20% indicates that the market is likely oversold.
Market Sentiment and Trading
Market sentiment indicators are an important part of many day traders’ toolkits, as they offer measures of otherwise intangible investor activity that is particularly useful during periods of high volatility and trading volumes.
Many day trading strategies specifically seek out markets where investors are trading emotionally, as these markets offer trading opportunities that are much rarer in more stable and rational market activity.
By offering a means of interpreting emotional trading activity using consistent measures, market sentiment indicators provide day traders with the ability to trade rationally while other investors are trading emotionally.
That said, market sentiment is notoriously volatile and fickle, so day traders should be aware that attempting to forecast it is always a tricky venture.
Market sentiment is important for day traders to understand, since many of the trading opportunities that day traders seek out are created by the kind of emotional investing that market sentiment indicators attempt to measure.
While market sentiment indicators can empower day traders to trade rationally in volatile markets, there are no guaranteed means of forecasting the behavior of emotional investors.