How do you perceive financial markets – do you anticipate they will ascend or descend in the future? If you can respond to that query, then you already have a grasp of your personal sentiment towards financial markets, whether you trade stocks, foreign exchange, or another security.

Emotion is a significant driver of financial markets, and this is one of the primary reasons investors can identify trading opportunities. Consider stocks, for instance, one of the key reasons share prices do not necessarily align with the company’s book value is because investors are looking beyond the fundamentals of the business and incorporating their sentiment, which can be swayed by a variety of factors.

This underscores the significance and influence of sentiment on markets, but it also emphasizes the necessity to combine it with other measures such as technical analysis or fundamental analysis.

Comprehending market sentiment is one aspect, but trading it is another. Incorporating market sentiment into your trading strategy is only beneficial if you can use it to stay ahead of the curve and execute trades before the rest of the market. There is a substantial difference between 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 need to utilize market sentiment to identify trends and jump on the bandwagon before it’s too late, and you’re left trading securities as they peak or bottom out.

So, how do you monitor the sentiment toward markets and how do you trade it?

Market sentiment embodies the overall mood of financial markets and the collective sentiment among traders, regardless of whether they trade foreign exchange, stocks, or other securities. Comprehending sentiment allows you to discern whether a market is optimistic or pessimistic about the future price movements of a security, such as a stock or currency.

When the market exudes positivity and optimism about the future, it is known as a bull market. Conversely, a market that is pessimistic and expects prices to decline is referred to as a bear market.

However, assessing market sentiment is a complex task. Market attitudes and outlooks are influenced by a myriad of factors, necessitating investors to cast a wide net to stay abreast of the ever-changing market dynamics.

Moreover, while the majority of the market may lean in a particular direction, each participant has their unique perspective on the market’s performance and future trajectory. While the majority opinion often shapes the overall market sentiment, there are contrarian investors who deliberately go against the prevailing sentiment. For instance, when the market is optimistic, a contrarian might adopt a pessimistic stance.

Market sentiment is reflected in the price movements of the relevant security. Rising prices suggest a bullish market, while falling prices indicate bearish sentiment.

Sentiment can vary across markets and often correlates with each other. When bullish sentiment begins to emerge in one market, bearish sentiment can surface in another, or vice versa.

Consider safe-havens like gold as an example. When equity prices fall, the price of gold often rises as investors seek to invest in a commodity that can retain its value, rather than risking their capital in uncertain stock markets. This trend reverses when equities rebound as money shifts from one to the other. A significant aspect of trading based on market sentiment is the ability to identify when a market is about to pivot, which is where elements of fear and greed come into play.

The prevailing sentiment in the market typically sets the overall tone. Most investors tend to follow the general price trend, but the bullish or bearish mindset will eventually reach its zenith. Recognizing when this peak has been reached is crucial for investors to avoid buying in when a price has reached its peak and is due for a downturn (a manifestation of greed), or selling out when a price is at its lowest just before it starts to rise again (a manifestation of fear).

The ability to detect the onset of fear or greed can aid in identifying those who typically sell off as prices hit the low point of a price movement, and those who follow the crowd and buy just as the market begins to decline.

For instance, if sterling had been trading between $1.00 and $1.10 over a month-long period and then started to rise significantly above $1.10, it could indicate that greed has infiltrated the market as positive sentiment gains momentum. Unless there is a solid reason for sterling to have breached a new high, the upward drive is likely to have been fueled by emotion and will eventually revert back to the $1.00-$1.10 range it was previously accustomed to. Fear operates in a similar manner but can trigger more impulsive reactions from investors, who are generally more worried about losing money than missing out on opportunities to make money.

In summary, fear and greed can ensnare investors, leading them to purchase overpriced securities or sell securities at a loss, or less profit than was achievable. However, identifying when fear or greed has taken hold presents investors with an opportunity, as they can then pinpoint when the market is about to pivot.

Market sentiment indicators are invaluable tools for investors seeking to understand the current mood of the market and predict future sentiment, thereby identifying undervalued or overvalued opportunities. However, these indicators should be used in conjunction with other technical and fundamental analyses to add depth to research, rather than serving as the sole authority on the outlook for financial markets.

Several indicators and tools are commonly used by investors to determine sentiment:

• Commitment of Traders (COT): Published weekly every Friday by the Commodity Futures Trading Commission (CFTC), the COT reveals the net long and short positions of speculative and commercial traders. This provides insight into market dynamics by detailing how the largest traders (such as hedge funds, banks, and corporations) are positioned in terms of futures and options, indicating their commitment to current trends. If the COT shows major traders shifting to a more bearish stance in what has been a bull market, this could suggest an impending market turn. With forex traded OTC, futures are used as a proxy to gauge 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 serve as a form of insurance for investors against potential price corrections. In this context, higher implied volatility signals greater fear that the current trend is about to reverse. Conversely, low implied volatility suggests stable sentiment and the likelihood of the current trend continuing.

• High/Low Sentiment Ratio: This simple indicator compares the number of stocks heading to their highest level over the previous 52 weeks to the number 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 provides a straightforward measure of market bullishness. The index uses point and figure (P&F) buy signals, listing the number of stocks within a given index that have generated a buy signal. Under P&F, stocks either carry a buy or sell signal, making it a 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 overbought and ready for a downturn. Conversely, 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.

• The put/call ratio is a tool that calculates the number of put options (which anticipate a price decrease) divided by the number of call options (which predict a price increase). A ratio below 1 signifies that more call options are being placed, implying that a greater number of investors are anticipating a price increase. On the other hand, a ratio value above 1 suggests that more investors believe the market may begin to slow down or decline. Similar to the previous indicator, this tool is most effective in identifying potential market bottoms, as elevated readings can persist for extended periods during an upward trend.

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