WHAT EVERY TRADER SHOULD KNOW ABOUT MARKET SENTIMENT

Markets are driven by emotion as much as by anything else. Value may drive prices in the long term, but in the short term, it is sentiment that drives prices. In this post, we will look at what market sentiment is, how to understand market sentiment, how it can be measured, and how you can use it to trade.

What is market sentiment?

Market sentiment indicates the mood and attitude of traders as a whole. When sentiment is positive, prices are more likely to rise, and if sentiment is negative, prices are more likely to fall. When sentiment reaches extreme levels, prices can also reverse.

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.

How to use market sentiment to trade

There are three ways sentiment can be used to aid your trading decisions. These are relevant on all timeframes, and it’s worth bearing in mind that sentiment can be positive on one timeframe and negative on another timeframe.

Firstly, when sentiment switches from positive to negative, you’ll need to keep an eye on any positions you have that may be affected. Usually, momentum will follow sentiment, but the trend may not yet have changed. This is when you’ll need to keep an eye on stop-loss levels and signs of a change in trend.

Secondly, positive sentiment can become even more positive, and negative sentiment can become even more negative. This is when momentum and volumes will probably pick up. If you are on the wrong side of such a move, it’s definitely time to get out. And if you are on the right side of a trade, this is when you may want to add to a position. Also, when sentiment in either direction is strengthening, you should not be taking profits, but riding the momentum for as long as possible.

Finally, when sentiment reaches extremes, you need to be looking for a price reversal. Prices reach their highest levels when sentiment is highest, and their lowest levels when sentiment is weakest. For the most part, you’ll want to trade in the direction of improving or weakening sentiment. But when sentiment indicators start hitting extreme levels, you should look to exit those positions and look for trades in the opposite direction.

Conclusion

These are just a few of the ways you can use market sentiment to trade. However, to really get the most out of it, you’ll need to put in some screen time to learn how prices action and sentiment affect one another. Using market sentiment is a great way to create your own strategies based on your own observations and the patterns you discover.

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