Understanding market sentiment can be a powerful tool for traders. Reading the mood of where the market is heading can allow you to capitalise from the changing direction. So, what is market sentiment and how do you trade it?
‘In the short run the market is a voting machine, but in the long run it is a weighing machine,’ – Benjamin Graham, renowned investor regarded as the father of value investing.
How do you feel about financial markets – do you think they will rise or fall in the future?
If you can answer that question, then you already understand what your personal sentiment is toward financial markets, whether you trade stocks, foreign exchange or another security.
Financial markets are fuelled by emotion and this is one of the main reasons investors can find opportunities to trade. Take stocks for example, one of the key reasons share prices do not necessarily match the company’s book value is because investors are reading beyond the fundamentals of the business and pricing in their sentiment, which can be influenced by all manner of things.
This shows the importance and impact of sentiment on markets, but also highlights the need to blend it with other measures such as technical analysis or fundamental analysis.
Understanding market sentiment is one thing, but trading it is another. Evaluating market sentiment, as part of your trading strategy is only worthwhile if you can use it to get ahead of the game and can make trades before the rest of the market. There is a big difference to how the market feels now and how it feels about the future, and only the latter provides investors with a trading opportunity. In simple terms, you have to use market sentiment to identify trends and join the bandwagon before it’s too late and you’re left trading securities as they top or bottom-out.
So, how do you track the sentiment toward markets and how do you trade it?
What is market sentiment?
Market sentiment represents the mood of financial markets and the general feeling among traders, whether they trade foreign exchange, the stock market or anything else. Understanding sentiment allows you to judge whether a market is feeling optimistic or pessimistic about the future of prices of a security, such as a stock or currency, for example.
If the market is feeling positive and optimistic about the outlook then this is referred to as bull market, and a pessimistic market that expects prices to fall is referred to as a bear market.
Gauging market sentiment, however, is tricky. Attitudes and the outlook of a market are both shaped by anything and everything, therefore investors need to spread a wide net to ensure they are informed as much as possible about the ever-evolving market they trade.
In addition, while the majority of the market will lean one way or another, every participant holds their own view on why the market is performing the way it is and where it is heading next. While the opinion of the majority often dictates the overall sentiment toward a market, there are the likes of contrarian investors who bet against the dominating sentiment – when the market is optimistic a contrarian will take a pessimistic view, for example.
Market sentiment is demonstrated through price movements of the security in question. If prices are on the rise, then this is indicative of a bullish market. Whereas prices on the decline point toward bearish sentiment.
Sentiment will differ depending on the market, and in some cases often correlate with one another. When bullish sentiment starts to surface in one market, bearish sentiment can emerge in another, or vice-versa.
Take safe-havens as an example, like gold. When equities are on the decline the price of gold is often on the rise, as investors look to plough their money into a commodity that can hold its value, rather than risking their capital on uncertain stock markets, before reversing when equities pick back up as money shifts from one to the other. A large part of using market sentiment to trade is being able to read when a market is about to turn, which is where fear and greed come into play.
Trading emotions: fear and greed
The dominant feeling in the market usually dictates the overall sentiment of a market. Most investors are conditioned to follow the general direction of prices, but eventually, the bullish or bearish mentality will peak. Understanding when that peak has arrived is important for investors so that they avoid buying-in when a price has hit its peak and faces a downturn (greed), or selling-out when a price is bottoming out just before it begins to rise again (fear).
Being able to spot any emergence of fear or greed is helpful in identifying those that are usually selling-up as prices hit the low of a price movement, and those that chase the crowd and buy just as the market heads lower.
For example, if sterling had been trading between $1.00 and $1.10 over a month-long period and then began rising significantly above $1.10, it could suggest greed has entered the market as positive sentiment snowballs. Unless there is good reason for sterling to have broken through a new high, the drive upward is likely to have been spurred on by emotion and, eventually, will fall back down to the $1.00-$1.10 range it was accustomed to. Fear works in the same way but can evoke more knee-jerk reactions from investors, which tend to be more concerned about losing money than missing out on opportunities to make money.
To summarise, fear and greed can catch out investors and see them buy over-priced securities or selling securities for a loss, or less profit than was possible. Spotting when fear or greed has taken over, however, presents investors with an opportunity as they can then identify when the market is about to turn.
How to trade market sentiment
Volume can be one way to evaluate how markets are feeling. This is particularly true for stocks and options as it can point toward rising or falling interest. If a company’s share price has continued to rise but volumes begin to drop-off, for example, then this could be indicative of weakening sentiment. In this context, it is important to remember that it is harder to measure volumes for forex because it is traded over-the-counter (OTC) rather than through a centralised market like a stock exchange, making data on items like trading volumes less reliable and harder to gauge.
Market sentiment indicators
Market sentiment indicators are one of the most helpful tools at the disposal of investors looking to judge how the market feels now and where sentiment is headed, helping to find undervalued or overvalued opportunities. However, these indicators should be used alongside other technical and fundamental analysis to provide added depth to research, rather than used as a single authority on the outlook for financial markets.
Some of the most widely used indicators and tools used by investors to pinpoint sentiment are:
Commitment of Traders (COT): The COT is published by the Commodity Futures Trading Commission (CFTC) on a weekly basis every Friday and shows the net long and short positions of speculative and commercial traders. This helps outline the market dynamics by detailing how the biggest traders (like hedge funds, banks and corporations) are positioned in terms of futures and options, showing how committed they are to the current trends. If the COT shows major traders have shifted to a more bearish attitude in what has so far been a bull market, then this could point toward an upcoming turn in the market. With forex traded OTC, futures are used as a proxy to gain an idea of the mood in forex markets.
Volatility Index (VIX): Also known as the ‘fear index’, the VIX tracks options prices and measures implied volatility – making it a useful tool compared to ones that focus more on the present or historic sentiment. Option prices are used as a way for an investor to protect themselves against any potential correction in prices, almost as an insurance policy. In this context, the higher the implied volatility the higher the fear that the current trend is about to snap. While low implied volatility suggests sentiment is stable and the current trend will continue.
High/low Sentiment Ratio: One of the easiest ways to find out whether the market is in a bullish mood, or a more bearish one, is the high/low sentiment indicator. This involves comparing how many stocks are heading to their highest level over the previous 52 weeks to the amount making 52-week lows. If the average direction of the market is toward the lows then the bears are in control, and when the market is closer to the highs the bulls are in charge.
Bullish Percentage Index: This index is a clear-cut way of finding out how bullish the market is. The index uses point and figure buy signals, listing the amount of stocks within a given index that have generated a buy signal. Under point and figure (P&F), stocks either carry a buy or sell signal to make it a very clear and unambiguous measurement of sentiment. The reading is presented as a percentage between 0% and 100%. Investors apply their own thresholds to this index to determine whether the market is over or undersold, but generally if 70% to 80% of stocks have buy signals then investors consider the market to be over-bought and ready for a downturn. While a reading below 30% or 20% would suggest the market is oversold and potentially ready to rise.
Stocks above/below moving averages: Moving averages help identify when a market could be about to break higher or lower. The percentage of stocks above or below key moving averages (for example the 50-, 100- and 200-day), say on the New York Stock Exchange (NYSE) for example, can help indicate whether the market is ripe for a rally or a drop. This can be used counter-intuitively, since having more than 70% of the index above its 200-day moving average is possibly a positive sign, it also indicates that much of the upward move has been completed. Instead, finding times when only a small percentage of the index is above the 50-day moving average, for example, can often be used to indicate dips within a broader uptrend that can provide entry points.
Put/call ratio: This measures the number of put options (which expect the price to go down) divided by the number of call options (which expect the price to rise). When the ratio falls below 1, this indicates that more call options are being placed, suggesting that more investors expect a bounce. Conversely, a ratio value above 1 will indicate more investors think the market may start to slow or fall. Like the previous indicator, the tool is best used to identify possible bottoms, since we can have elevated readings on both for extended periods of time on the upside.
Emotions are the key to understanding financial markets. However, it’s tough to make rational decisions based on them. Even if you think you read your emotions or other people’s emotions, you may get lost in trying to comprehend the feelings of the crowd. And the market sentiment is the emotions of millions of traders around the world. If you’d like to know more about it, read
The behaviour of the masses works differently from the mechanism that determines individual actions. The discovery is quite old and well described in a book by a French anthropologist Gustave Le Bon in 1895 “The Crowd: A Study of the Popular Mind.” The author states some of the characteristics of the psychology of the crowds:
“impulsiveness, irritability, incapacity to reason, the absence of judgment of the critical spirit, the exaggeration of sentiments, and others…”
Every trader knows the importance of emotions. You can see it in market volatility; you can see that some stock is overvalued in comparison to the company’s fundamentals, and others are undervalued.
Just like people on a rock concert, football game, or political demonstration transcend from individuals to a crowd, traders around the world create an entity that has its emotions and moods. The state of mind of the crowd of traders is called market sentiment.
The market sentiment is one of the three possible pillars for any trading strategy:
Fundamental Analysis / Trading the News
Reading Market Sentiment
For Forex and especially cryptocurrency traders fundamental analysis is much more difficult to apply than on the stock market. That is why these markets traders focus on technical analysis.
Bulls, bears and “dumb money”
Understanding the sentiment will let you know whether the crowd is optimistic (bull market), cautious or pessimistic (bear market) about a currency, stock or crypto. Identifying the current trend can help you predict the future overall market sentiment and will open sentiment-based trading opportunities.
Market sentiment works for all kind of markets, but can be difficult to read. There are big players, such as institutional banks that can play against the prevailing sentiment, and seek for so-called “dumb money.” Wait until the crowd gets all in on a particular position – be it long or short – and use the trading power to incite a reversal. I can teach you how to spot those traps.
Follow or go against the market sentiment
There are two possible strategies for using the market sentiment. You can go with the current and try to join the crowd or trade against the sentiment. The first strategy would include tactics involving the Fibonacci retracement tool that can help traders profit from local price corrections.
The second strategy is all about hunting for reversals identifying support and resistance levels and taking into consideration the overall market sentiment to decide whether a breakout may happen.
Safe-havens play an important role when the market sentiment goes to extremes, or there’s an overwhelming uncertainty. Assets like gold, USD, CHF or JPY are considered an excellent shelter in case of too much risk. When more volatile assets are entering a bear market, traders (including the most prominent players) tend to seek these safe-havens, which automatically create a bull market on ultra safe assets.
The two most dominant emotions
Fear and greed are the most dominant emotions among traders. They are either afraid of losing money, or they want to earn more. Greed is overwhelming at market peaks when the bubble is created.
A classic example of greed taking over in the peak of 2017 Bitcoin bubble
More and more people open the same long position on a hot asset be it a tech company, a currency of a fast-growing economy or a popular cryptocurrency. Just take a look at the most significant burst in crypto.
On the other hand, fear takes over when the market hits bottom. Traders are panicking underestimating the real value of an asset. A savvy investor can see an opportunity for opening a long position in these situations. However, trading against the trend always involves high risk.
How to identify fear or greed? When you see a trend accelerating breaking new resistance levels without any fundamental explanation – no critical information that would justify it – you may expect the greed is in action. The same mechanism works the other way around with fear. If during downtrends support levels are broken without an apparent reason, the fear may have taken over.
How to spot “dumb money”
“Dumb money” is where traders are taking the most popular and the most obvious moves. Everyone takes the hottest position; more and more people join and put themselves in a very vulnerable position.
Let’s take a look at Forex, a market where individual traders compete with the largest banks to make successful trades. Forex is as susceptible to market sentiment. Both the biggest institutional traders and the smartest individual traders see where the “dumb money” goes. Then when there’s the right time, the most prominent players open an opposite position and take the profit.
You can find indicators that show the number of traders having a short or a long position on an instrument. It turns out that the market almost always suddenly goes the other way rapidly cleaning the trading accounts of those who “hang out with the popular kids,” that follows the crowd.
The market sentiment is very easy to read if you take a look back. Everything seems to be visible. Even if you are new to trading, you can easily spot greed taking over just when the bubble is about to burst. However, at the time of the bubble, hardly anyone notices it, even the wisest and most experienced traders.
It’s difficult to profit directly from fear or greed taking over. Even if you can read the past and present sentiment correctly, you need to know what the collective traders’ mood will be like tomorrow. Without any insider knowledge or ability to influence the prices with your trading volume it’s impossible to do it repetitively.
What is the best market sentiment strategy?
Keep away from it. If you don’t use the most popular technical analysis tools and don’t trade reversals, you can avoid the riskiest moves. If you don’t want to play the “dumb money” but avoid it, you can focus on developing an effective trading strategy. You don’t have to know where the “dumb money” will go. All you need to know is where the “dumb money” is usually and at present.
There’s no good way to chase sentiment. It doesn’t matter if you want to trade along with it or against it. Guessing the future sentiment is a risky move, that’s why avoiding market sentiment at all may prove to work best for you. Doing so you could develop a sustainable trading strategy with the right mixture of technical and fundamental analysis.
Track market sentiment as part of your wider analysis
To summarise, there are numerous ways to measure market sentiment and get ahead of the market before big moves occur. Tracking sentiment alone is not enough to form the basis of a trading strategy but can be a useful addition to help add depth to an investor’s analysis of where markets are heading.
Market sentiment should not be underestimated – people and their perception is what drive markets higher or lower. News and developments are never-ending in financial markets; investors should try to take in as much as possible and listen to both the bulls and the bears to gain as complete a picture of the psychology of the market as possible and, more importantly, where it could be going next.
Don’t chase the sentiment, use it - don’t be a herd trader.