Sentiment Trading Strategies (Indicators, Setups, Rules, Backtests Findings)

Also known as investor attention or crowd psychology, market sentiment indicators refer 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 trading strategies and indicators are a variety of technical and statistical methods used to measure market sentiment. We provide you with several sentiment market indicators and backtests.

Table of contents:

What is Sentiment Trading? Understanding market sentiment

In sentiment trading, market sentiment plays a crucial role in guiding traders and investors in their decision-making process. By understanding and measuring market sentiment through various sentiment indicators, traders can gain insights into the overall mood of the market and anticipate potential price movements. This article explores the concept of sentiment trading and its importance, as well as how to use sentiment indicators in trading strategies.

Market sentiment refers to the prevailing attitude or sentiment of market participants towards a particular security or financial market. It can be influenced by various factors such as economic news, geopolitical events, and investor behavior. Sentiment indicators are tools that help quantify and gauge market sentiment, providing traders with valuable information to make informed trading decisions.

Sentiment trading strategies

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?

Below we have a list of articles about market sentiment strategies and indicators:

We also would like to give you a humble reminder that we have a full list of trading strategy examples (hundreds!)

Eager to learn more, let’s dive in.

What is a sentiment indicator? How to measure market sentiment?

One of the key reasons why sentiment trading is important is because sentiment can significantly impact stock market movements. Positive sentiment, often driven by optimism and confidence, can lead to bullish market conditions, while negative sentiment, driven by fear and uncertainty, can result in bearish market conditions. Similarly, sentiment also plays a crucial role in forex trading, as global economic factors and market sentiment can significantly affect currency exchange rates.

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

How do you trade with sentiment? 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?

How to measure market sentiment? 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. What is the best sentiment indicator?

A bearish sentiment, on the other hand, means that most investors expect the prices to decline, so they sell their assets.

Market sentiment indicators – the role of sentiment indicators in trading

To effectively use sentiment indicators in trading strategies, traders can combine them with technical analysis. By analyzing sentiment indicators alongside price and volume data, traders can gain a comprehensive view of the market and identify potential trading opportunities. Sentiment indicators can also help identify bullish and bearish sentiment signals, allowing traders to enter or exit positions based on prevailing market sentiment.

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:

AAII And Market Sentiment Indicators

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.

Consumer Confidence And Stock Market Returns (Strategy And Backtest)

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:

Investors Intelligence Sentiment Index (Contrarian Sentiment Indicator)

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:

What Is The Put Call Ratio? Does It Work?

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:

NAAIM Exposure Index

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.

NAAIM Exposure Index (Backtest Trading Strategy)

Is a sentiment based trading strategy profitable?

A sentiment-based trading strategy can be profitable for traders, but it also carries significant risks and challenges. This type of strategy relies on analyzing market sentiment, which is the collective mood and attitude of traders and investors, to make trading decisions. As you can see in our strategies and examples it is possible to make money and be profitable trading sentiment trading strategies.

Market Sentiment and Sentiment Indicators

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.

Sentiment Trading Strategies

Sentiment trading strategies are investment approaches that rely on analyzing market sentiment, which is the collective mood, attitudes, and emotions of market participants, to make trading decisions. These strategies aim to capitalize on the idea that investor sentiment can influence asset prices, sometimes leading to mispricing or trends that can be exploited for profit. Here are some common sentiment trading strategies:

Contrarian Trading:
- Buy Low, Sell High: Contrarian traders go against prevailing sentiment. When sentiment is excessively negative, they may buy an asset, expecting it to rebound as sentiment improves. Conversely, they may sell when sentiment is overly optimistic, anticipating a correction.
Momentum Trading:
- Follow the Trend: Momentum traders follow the direction of prevailing sentiment. If positive sentiment is driving an asset’s price up, they may buy in anticipation of further gains, and vice versa for negative sentiment.
News-Based Trading:
- Event-Driven: Traders react to news events and market sentiment shifts caused by news. This can involve trading on earnings announcements, economic data releases, or geopolitical events.
Social Media Sentiment Analysis:
- Sentiment from Social Media: Some traders use sentiment analysis tools to monitor social media platforms, such as Twitter or Reddit, to gauge public sentiment about specific assets. They may make trading decisions based on this data.
Options Trading Strategies:
- Implied Volatility: Options traders may use implied volatility as a gauge of market sentiment. High implied volatility suggests increased uncertainty, which can lead to options strategies like straddles or strangles.
Sentiment Indexes:
- VIX (Volatility Index): The VIX, often referred to as the “fear gauge,” measures implied volatility in the options market and can be used as a proxy for market sentiment. A high VIX indicates heightened fear or uncertainty.
Technical Analysis with Sentiment Indicators:
- Combine with Technical Analysis: Traders may combine sentiment indicators with technical analysis to make more informed decisions. For example, using sentiment data alongside moving averages or chart patterns.
Market Sentiment Surveys:
- Professional Surveys: Analysts and traders sometimes rely on market sentiment surveys to gauge the consensus opinion of market professionals. These surveys may help inform trading decisions.
Behavioral Finance Insights:
- Behavioral Biases: Sentiment trading also considers behavioral biases, such as herd behavior and overreaction to news. Traders may exploit these biases when making decisions.
Quantitative Models:
- Quantitative Sentiment Models: Some traders develop quantitative models that incorporate sentiment data, such as sentiment scores from news articles or social media, into their trading algorithms.

How does sentiment affect stock market movements?

The impact of sentiment on forex trading

Using sentiment indicators to make informed trading decisions

How to Use Sentiment Indicators in Trading Strategies?

Several common sentiment indicators are widely used by traders in different financial markets. The Volatility Index (VIX), also known as the “fear index,” measures market volatility and investor sentiment. The Commitment of Traders (COT) report provides insights into the positions and sentiments of different types of traders in futures markets. Additionally, the 52-week high/low is often used as a sentiment indicator, where new highs or lows can indicate bullish or bearish sentiment, respectively.

Combining sentiment and technical analysis

Identifying bullish and bearish sentiment signals

Applying sentiment indicators in different financial markets

Common Sentiment Indicators Used by Traders

Please have a look at the list of linked articles in the beginning of the article.

Contrarian Trading and Sentiment Analysis

Contrarian trading, a strategy that goes against prevailing market sentiment, is also prevalent in sentiment trading. By identifying sentiment extremes, where the majority of market participants are overly bullish or bearish, contrarian traders aim to capitalize on potential reversals or market corrections. However, it is essential to acknowledge the limitations of sentiment analysis and consider other fundamental and technical factors when making trading decisions.

The role of contrarian strategies in sentiment trading

Contrarian trading, a strategy that goes against prevailing market sentiment, is also prevalent in sentiment trading.

How to identify sentiment extremes for contrarian trading?

By identifying sentiment extremes, where the majority of market participants are overly bullish or bearish, contrarian traders aim to capitalize on potential reversals or market corrections.

The limitations of sentiment analysis in trading

It is essential to acknowledge the limitations of sentiment analysis and consider other fundamental and technical factors when making trading decisions.

FAQs:

Q: What is sentiment trading?

A: Sentiment trading is a trading strategy that involves making trading decisions based on market sentiment, which refers to the overall attitude of market participants towards a particular asset or market.

Q. Why is sentiment trading important?

Q: How can market sentiment be measured?

A: Market sentiment can be measured using various methods, such as analyzing market sentiment indicators, monitoring social media sentiment, or using surveys and sentiment analysis tools.

Q: What is a market sentiment indicator?

A: A market sentiment indicator is a tool or metric that helps traders gauge the overall sentiment or mood of the market. It can provide insights into whether the market is feeling bullish or bearish.

Q: Why is understanding market sentiment important for traders?

A: Understanding market sentiment is important for traders as it can provide insights into potential market trends and help traders make more informed trading decisions. It can also help in identifying potential trading opportunities.

Q: What are some sentiment trading strategies?

A: Some common sentiment trading strategies include contrarian trading, momentum trading, and sentiment-based pattern recognition. These strategies involve making buy or sell decisions based on the prevailing market sentiment.

Q: What role do technical indicators play in sentiment trading?

A: Technical indicators can be used in sentiment trading to confirm or validate market sentiment signals. They can help traders identify potential entry and exit points based on the prevailing sentiment.

Q: Is sentiment trading suitable for all investors?

A: Sentiment trading may not be suitable for all investors as it involves higher risk and requires deep understanding of market sentiment and trading strategies. It is important to carefully consider one’s risk tolerance and investment goals before engaging in sentiment trading.

Q: How can I use IG client sentiment data in sentiment trading?

A: IG client sentiment data provides insights into the positioning of retail traders. It can be used as an additional tool in sentiment trading to gauge the sentiment of retail traders and potentially identify contrarian trading opportunities.

Q: How does fear and greed impact market sentiment?

A: Fear and greed are psychological factors that can greatly impact market sentiment. When fear dominates, it can lead to bearish sentiment, while greed can drive bullish sentiment. Traders need to be aware of these emotions and their influence on market sentiment.

Q: How can I measure the bullish market sentiment?

A: Bullish market sentiment can be measured by analyzing various indicators, such as the number of stocks making 52-week highs, the percentage of stocks trading above their moving averages, or by monitoring the sentiment of market participants through surveys or sentiment analysis tools.