Market sentiment indicators
Market sentiment itself cannot actually be measured, but the actions of traders and the behaviour of certain asset prices can give us an idea of what traders are thinking. We, therefore, use proxy indicators to give us an idea.
There is no single market sentiment indicator that can be applied in isolation or to every situation. Each market is driven by different factors, and a different set of clues will point to its market sentiment. Forex traders, for example, are most concerned with inflation and interest rates, while stock traders are concerned with corporate revenues and earnings.
Effective market sentiment analysis requires looking at a variety of indicators that provide clues about what other traders think about a currency pair, stock, or index.
Safe haven assets are a very good indicator of the overall mood of investors around the world. When investors get nervous, they will move capital to instruments they believe to be safe. These include gold, US treasuries, US dollars and Swiss Francs. If sentiment is negative, the prices of these assets usually rise. When risk appetite returns, the prices of these assets will often fall.
By contrast, the prices of risky assets rise when overall market sentiment is positive. Risky assets include small-cap stocks, junk bonds, and emerging market currencies and other assets.
The Vix Index is another widely followed sentiment indicator. It is an index of the implied volatilities of S&P 500 options, which rise when market volatility and uncertainty rise.
Other indicators that give a good reading on global market sentiment are the put/call ratio, the stock price breadth index, and the advance-decline index.
CNN’s fear and greed index combines 7 different sentiment indicators and gives a reading between 1 and 100. A reading of 1 indicates extreme levels of fear, while a reading of 100 implies extreme greed.
The indicators listed above are relevant to overall market sentiment. When one is looking at individual instruments, certain technical indicators can be used. For short term trading, a 2-period RSI can be used to indicate extreme sentiment levels. Most momentum indicators can be used to give you an indication of sentiment switching from positive to negative and vice versa.
The platform you use will also dictate your choice of market sentiment indicator. MT4 includes many standard indicators that can be used to measure sentiment, and a lot of custom indicators can be downloaded too. Before trading with any indicator, you should monitor it and see how well it performs.