Market sentiment generally refers to the attitude investors have towards either a security or the general market’s outlook.
A strategy that has a basis on sentiment, on the other hand, will try to decipher those feelings with a logical approach.
So rather than being under the heel of a sentiment, you must know how to effectively capitalize on it instead.
In terms of strategy, the market’s optimism or pessimism can be reflected in the overall price trends, as such trading in parallel with whichever sentiment is prevalent can actually be effective.
Herd instinct, however, will also attract contrarian investors.
So, as an individual investor where can you look do to have an edge?
VIX, also known as “The Fear Index”
The VIX will increase in times of increased volatility so if you’re seeing it rise, you know what to expect.
The Bullish Percent Index (or BPI)
The BPI can help you grasp market sentiment as it will display bullish patterns over a given period, as well as provide you an estimate on how over-bought securities might be at the time.
If you see it hover above 80%, you can be on a positive market sentiment .
However, if you find it under 20%, it is because for the time being negative sentiment is prevailing.
The High-Low Index
This handy index will compare the number of stocks which go for 52-week highs, versus the ones which go for 52-week lows.
Consequently, having a high value on this index is considered by investors as evidence of a bullish market, whereas a low value will attest to a bearish market sentiment.
Moving Averages
Looking at a security’s moving average in a 50 or 200-day period can be useful as to spot patterns which, in turn, might reveal sentiment.
When these moving averages cross, it tends to signal a noteworthy momentum change.
52-week average:
Depending on where a stock is trading relative to its 52-week price, one can argue that its position may depict the market’s sentiment towards it.
Other hints
If you find yourself looking at a security which simply cannot break a certain resistance, that behavior may in fact signal a sentiment flag.
Other flags include, for instance, a forming triangle pattern or a growing short position.
Arguments against sentiment trading
One can argue that sentiment can often be irrational or, even if there is a prevalent sentiment towards a certain security, investors might be unwilling to act upon it.
Another issue with sentiment trading is how fast sentiment can change and how hard it might be keeping up with those changes.
Don’t rule out technical analysis
Sentiment can, without a doubt, work as a price catalyst but they are far from being the only part of that equation.
As such, it is important that, even when crafting a sentiment-based strategy, investors don’t discard technical analysis and fundamentals.
Wrapping up
Sentiment trading means quite the opposite of “sentiment”.
It means rationality in face of however the market might be behaving, especially when taking a position.
As such, when forming a thesis based on the understanding of the market’s sentiment, you will find that finding context in a security’s momentum is going to play a key role.
To do so and find a more reliable pattern, you may draw from its historical behavior, by looking at its action in tandem with other sector averages, etc.
It is a hard endeavor for one to trade in an empathetic way while simultaneously having to be analytic and data-driven, because you will often find yourself wanting to join in and “catch a ride” on a trend, only for your data to oppose that momentum chase.
