How Market Sentiment Affects Trading?

Investors and traders in the stock market use various methods to evaluate market conditions. Fundamental and technical analysis have long been trusted methods. However, some market participants find traditional analytical tools insufficient. To improve their decision-making accuracy, whether to open trades or close positions, they rely on additional comprehensive indicators. One of these is market sentiment.

Market Sentiment – General Definition

Market sentiment refers to the overall attitude of investors towards a particular asset or the market as a whole. If the sentiment is positive, it leads to an increase in buying activity. Conversely, a negative sentiment results in more selling. This drives bullish or bearish trends in price movements.

Market sentiment isn’t always dictated by fundamental factors or technical indicators. Since it reflects the opinions of the majority (“the crowd”), there can be a significant emotional component. For example, a sharp price spike on a chart might prompt many investors to see it as the start of a bullish movement and decide to join in, even if fundamental or technical analysis doesn’t confirm this view.

Market sentiment can play a decisive role in shaping a trend, even if there are no objective reasons for its development. As in the example above, the emotional decision of a large number of market participants to buy can push prices even higher. This, in turn, will increase the number of bullish investors, further driving prices upward. In such cases, it is the sentiment of the crowd, rather than rational analysis, that moves the market.

Naturally, experienced market participants try to monitor market sentiment. From their perspective, the ideal tool for this is the order book, which shows the volume of buy and sell orders for an asset. While this approach has its merits, it would be a mistake to call it exhaustive. Here’s a simple illustration:

In trading ABC company shares, 10 traders place buy orders of 1 lot each. Another investor places a limit order to sell 20 lots. As a result, the price moves downward after the orders are executed.

There’s an apparent contradiction:

• The majority of traders (10 out of 11) expect a bullish scenario.
• However, the order volumes indicate bearish sentiment and drive the price accordingly.

Can we definitively say what the prevailing market sentiment is in this situation? Of course not. For instance, optimists may stick to their own views, increase their positions, and compensate for the price drop caused by the large sell order. But there’s also an equally possible outcome: the falling prices might increase the number of pessimists who, by placing their own orders, will push the prices even lower.

Note! In real market trading (visible in the order book and trade feed), participants can only see order volumes and trading transactions. Therefore, information about market sentiment can’t be called complete. This is especially true for illiquid assets. For highly liquid ones, where thousands of trades occur daily, the representation of market sentiment based on volume can be considered close to reality.

Ways to Determine Market Sentiment

Investors use various methods to determine market sentiment.

VIX Fear Index

This index is calculated by the Chicago Board Options Exchange and is officially called the Volatility Index for options. It’s believed to reflect investors’ expectations regarding future volatility of a financial instrument. Low values indicate market fears and dominant bearish sentiment. High values, on the other hand, suggest investor optimism and a higher likelihood of a bullish scenario. The CME calculates this index based on S&P 500 options, so it generally applies to the U.S. stock market.

Extreme VIX levels can be interpreted as boundary points in market sentiment, which precede a reversal. For example, many experienced investors view low VIX levels as a signal to start buying, while high levels suggest a good time to begin selling. To more precisely identify sentiment shifts, moving averages are often added to the VIX chart.

Index of Highs and Lows

This index is used to determine the sentiment of a specific market as a whole. It is based on comparing the number of assets that have reached their yearly (52-week) highs and lows. Typically, it is calculated for instruments included in leading indices, such as the S&P 500, NASDAQ 100, or NYSE Composite. It can also be realistically calculated for individual industries and sectors.

Characteristic threshold values are used in the calculations:

• 30% and below – bearish market sentiment, with a high likelihood of price declines.
• 70% and above – bullish sentiment.

The range between 30% and 70% – indicates uncertain sentiment, requiring additional signals to make decisions.

Experienced investors use this index in other ways as well. For example, breaking out of the 0-30% zone is seen as a shift from bearish to bullish sentiment and a signal to buy. Similarly, dropping below 70% indicates a shift from bullish to bearish sentiment and signals it may be time to sell.

Bullish Percentage Index (BPI)

The calculation of this index is based on using specific types of price charts (such as Point & Figure or Renko charts). To determine the current value of the BPI, the ratio of assets with bullish patterns on their charts to the total number of assets, for example, in a stock index, is calculated.

The threshold value for a sentiment shift is considered to be 50%. When the index is above 80%, it is believed that the market is overly optimistic, the assets may be overbought, and a trend reversal or correction is expected. Similarly, when the BPI is below 20%, the market is excessively pessimistic, and assets are considered oversold.

Moving Averages

Typically, a combination of two simple moving averages (SMAs) – the 50-day and 200-day – is used to determine market sentiment. When the faster average crosses the slower one from below (known as a “golden cross”), it indicates a bullish momentum in the market and a shift in investor sentiment. Conversely, when the 50-day SMA crosses the 200-day from above, it forms a “death cross,” indicating a potential market decline.

Market sentiment is usually determined based on already developing events. Most methods for identifying it are lagging indicators. Therefore, it is irrational for investors to rely solely on this indicator. There is a high likelihood of making decisions too late, resulting in losses instead of the anticipated profit.