Last Updated on July 17, 2022 by Oddmund Groette
As a trader or investor, it is necessary to understand the mood of the market at every point in time, and market sentiment can be a powerful tool for that. But what is market sentiment and how do you measure it?
Also known as investor attention or crowd psychology, market sentiment refers to the prevailing attitude of investors as regards expected price development in a market. It is the feeling or tone of a market, as revealed through the activity and price movement of the securities traded in that market. Sentiment indicators are a variety of technical and statistical methods used to measure market sentiment. We provide you with several sentiment market indicators and backtests.
Eager to learn more, let’s dive in.
What is a sentiment indicator?
A sentiment indicator is any tool used to measure the mood of the market by analyzing trends, market activity, and the economy from the perspective of the participants involved, rather than just looking at an asset or data point isolation. Investors use sentiment indicators to gauge how optimistic or pessimistic people are about the current market or economic conditions.
There are various indicators they can use to measure market sentiment to know the best stocks to trade and when to trade them. Some of the most commonly used sentiment indicators include the CBOE Volatility Index (VIX), High-Low Index, Bullish Percent Index (BPI), and put/call ratio.
These sentiment indicators gauge market psychology in the form of investor behavior, but there are other sentiment indicators that monitor consumer behavior which is believed to influence the market. Typically, when a sentiment indicator is moving in the same direction as the market parameter it is analyzing, investors see it as a confirmation of the trend.
However, when the readings of a sentiment indicator are extreme readings, some traders may take a contrarian view of the market — for example, they buy when there is a high level of fear and sell when there is greed. Whichever way, it is not advisable to trade based on sentiment indicators alone. Combine them with technical and fundamental analysis.
Sentiment indicators examples
There are many types of sentiment indicators, but let’s take a look at these ones:
- Advance/Decline (A/D) line: It plots the difference between the number of advancing and declining stocks on a daily basis. It tells traders whether there are more stocks rising or falling, so it is used to confirm price trends in major indexes — a rising A/D line during a rally confirms the uptrend, and a falling A/D line during a downtrend confirms the downtrend.
- Put/Call ratio: It represents a proportion between all the put options and all the call options purchased on any given day. When it has a very high reading (relative to historical values) it shows investors are expecting stock market prices to decline. On the other hand, when it has a very low reading, it shows that prices will likely rise, as there are few people left to keep pushing prices lower.
- CBOE Volatility Index (VIX): Often seen as the “fear index”, it rises sharply when investors purchase a significant amount of SPX put options to protect their portfolios. Investors buy put options when they believe the market is about to decline, so a spike in the VIX indicates fear within the market.
- New York Stock Exchange (NYSE) High/Low Indicator: This compares stocks making new 52-week highs relative to stocks making new 52-week lows. A spike in either direction implies extreme bullishness or bearishness, which contrarian investors can use to trade in the opposite direction.
What is sentiment in the stock market?
In the stock market, sentiment is the prevailing mood of investors as regards the anticipated price development in a market. It is the tone of a market, as revealed by crowd psychology through the activity and price movement of the general market. Generally, rising prices indicate bullish market sentiment, while falling prices indicate bearish market sentiment.
Investors’ mood is a function of the accumulation of a variety of fundamental and technical factors, including price history, economic reports, seasonal factors, and national and world events. All these factors affect investors’ behavior and consequently, how the market moves. When investors are optimistic about the market, they keep buying, which pushes up the prices. On the other hand, when investors are pessimistic about the market, they sell their assets to stay in cash.
What does bearish and bullish sentiment mean?
Investors typically describe market sentiment as bearish or bullish. A bullish sentiment means investors expect upward price movement in the stock market. In such a situation, they are more likely to keep buying and pushing the price up.
A bearish sentiment, on the other hand, means that most investors expect the prices to decline, so they sell their assets.
Market sentiment indicators
There are plenty of market sentiment indicators. We have covered a few of them on this website. Let’s look at a few of them:
AAII Sentiment Indicators
AAII sentiment indicator is a widely used and referred to indicator.
AAII stands for American Association of Individual Investors. The index is updated once a week and shows the sentiment among the AAII members. We did a backtest to show the performance of the indicator:
Consumer confidence sentiment indicator
Consumer confidence reveals the “temperature” in the economy. Just like Mr. Market, the consumer confidence swings from one mood to the other – perhaps a bit manic depressive. Consumer confidence is published monthly by the Conference board.
We have backtested this sentiment indicator, and we found out that the stock market performs better when consumer confidence is bearish as a contrarian indicator.
Investors Intelligence Sentiment Index
Investors Intelligence Sentiment Index is also known as the Advisor Sentiment and is based on contrarian propositions. We have not backtested this indicator, but we made a summary in a previous post:
The Put Call ratio
The put call ratio looks at the relationship between the number of puts and calls (volume or open interest). There are many different puts and calls and hence you can choose among many ways to backtest.
Our own backtests on the put call ratio determine that there are better fear indicators out there:
We regard VIX as the best fear indicator:
VIX fear index
The VIX is an indicator that is based on the implied volatility of S&P 500 options. The more fear in the market, the more traders and investors are willing to pay for insurance. Options work just like insurance. If you own put options you have the right to sell (but not the obligation) at a predetermined price (strike) within a certain timeframe (expiration date).
The implied volatility can be used as a fear indicator, thus S&P 500 and the VIX are inversely related. We have written many articles about the VIZ and below you find three articles including both backtests and strategies:
- Using VIX To Trade SPY And The S&P 500 (VIX Trading Strategies)
NAAIM is an abbreviation for National Association of Active Investment Managers (NAAIM). It measures the exposure to equities by its members by using a two-week average of the responses by the members. It’s mainly used as a contrarian indicator.
Market Sentiment and Sentiment Indicators – ending remarks
The relationship between the stock market and sentiment is mostly inversely related and they could be used as contrarian indicators. However, we believe these indicators work better on longer term horizons – most likely many months. For short-term trading, we believe the “standard” oscillating indicators work better than sentiment indicators.