Do you know how to measure market sentiment? Market sentiment is fairly easy to define: invest in investors’ attitude and tone. Defining it is easy, but measuring and taking advantage of it is another story. Why is market sentiment important? It is one of the major ways that traders and investors can try to predict what a market will do. At the very heart of it, there are two types of market sentiment:
- Bullish market sentiment leads to stock prices rising.
- Bearish market sentiment leads to stock prices falling.
Did the above description make sense? It’s easy to get dissuaded and bearish when all we see is red.
At the same time, it’s easy to get excited and bullish when stocks are green.
Market sentiment plays a very important role in various trading strategies.
Remember, there is an understanding of how market sentiment works and what its effects will be. Then, there is measuring market sentiment to use to your advantage as a trader. Do you know how to measure market sentiment? Let’s See how exactly you can measure the current market sentiment!
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How to Measure Market Sentiment When Trading
Do you know how to measure market sentiment? There are a lot of ways to measure market sentiment accurately. The easiest way is to look at the markets over a set period to see how they behave. If the S&P 500 is trading higher on one day, it doesn’t mean the sentiment is all of a sudden bullish.
Zoom out, and you might see the index is down by 5% over the past month. You would have to conclude that sentiment is overall bearish, and overalls happen amid bearish downtrends and vice versa.
Market sentiment should always be measured against different time frames. Sentiments can change over a year, a quarter, a month, a week, and even during a single trading session.
1. Stock Price Action
Let’s talk about how to measure market sentiment with price action.
The easiest way to determine a simple reading of market sentiment is to check the recent price action of stocks and indices.
Over a specific range, the direction they are trending should give you an idea of whether sentiment is currently bullish or bearish.
If you want to get specific, you can also factor in some technical indicators which I will get to later.
2. The VIX
What is the VIX? It is more commonly referred to as the Volatility Index or Fear Index. The CBOE, or Chicago Board Options Exchange, started the VIX in 1993. It measures the implied volatility derived from the price of S&P 500 options contracts.
As option premiums change, we get a clearer picture of market volatility and sentiment. The more volatile the market is, the more bearish the sentiment is.
The VIX measures a 30-day, forward-looking volatility window, an excellent mechanism for measuring future sentiment. So, if you’re learning to measure market sentiment, then you know the VIX is a go-to tool.
3. Social Media Sentiment
Did you know you can use social media when figuring out how to measure market sentiment?
Yes, social media sentiment is a thing now. Even before the Reddit short squeeze in 2021, social media platforms like Twitter played a major role in shaping market sentiment.
Fintwit and Reddit are two excellent gauges of what stocks or cryptocurrencies people are discussing. How can you find all of this in one place?
Sites like Chatterquant provide a real-time, web-based app that measures social media sentiment. It takes the number of times a stock or crypto ticker is mentioned and whether or not the sentiment for those mentions is bullish, bearish, or neutral.
Be careful when using social media sentiment, though. Many people on Fintwit and Reddit will pump or push down stock for their gains. You should never use anything that is posted on social media as a reason to buy or sell a stock.
Rather, you can use social media sentiment to gauge how investors feel. Some savvy traders will even trade against this sentiment, especially when sentiment becomes overly bearish or bullish.
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Fundamental Analysis vs Technical Analysis
These are two more tools you can when learning how to measure market sentiment, as well as predict how a stock will behave. The two types of analysis often work in tandem with each other.
A general rule of thumb is that technical analysis helps traders and fundamental analysis helps investors. Let’s see how fundamental and technical analysis can help you gauge the markets.
1. Fundamental Analysis
What is fundamental analysis? It is a look into how the company is affected by macroeconomic and microeconomic factors.
Compared to technical analysis, fundamental analysis looks at the broader picture and how the stock and company will be affected.
In essence, fundamental analysis is trying to determine the stock’s fair market value.
You can use fundamental analysis to forecast a stock’s performance. Things like earnings calls, new product launches, or even management changes qualify under fundamental analysis.
You can also use financial measures like revenue growth, profit margins, or price-to-earnings ratios. If a stock is priced way over its actual value, then you can determine that sentiment for this stock is too bullish.
We can reasonably expect this stock price to pull back at some point in the future, providing a more attractive entry point. When learning how to measure market sentiment, you can use fundamental analysis.
2. Technical Analysis
Technical analysis is popular amongst traders and studies stock charts and past performance. Analysts believe they can predict when and where a stock will trade using previous support and resistance zones. Technical analysis is especially useful for day and swing traders since they can use it to time an entry or exit.
How do you use technical analysis to determine market sentiment? Certain technical indicators can be used to measure if a stock is overbought or oversold.
What is another word for overbought or oversold? Bullish or bearish. Some indicators include the RSI, relative strength index, MACD, or Moving Average Convergence Divergence.
These follow the stock’s price action and moving average prices to determine support and resistance. It’s not a perfect science, but it gives us a good idea of how the market views the stock. So, use it when figuring out how to measure market sentiment.
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Which Market Sentiment is Better: Bullish or Bearish?
It comes down to what kind of trader you are. For example, a long-term investor will likely enjoy bullish sentiment, whereas a short-seller might prefer bearish.
You can make money in either market, especially if you trade options.
You can also use market sentiment to your advantage by trading hedges to protect your portfolio.
If a market is overly bullish, you can hedge with some puts on the stocks you own or the S&P 500 index.
Investors feel psychologically better when the market sentiment is bullish in the grand scheme of things. We like to think about how large our investments can grow, and there is something more appealing about the color green.
Investors naturally have bullish sentiment. After all, it’s where we get the saying ‘stonks only go up.’ Experienced traders know this is far from true. Just look at how the markets have performed so far in 2022.
So, while bullish markets are more fun for investors, bear markets are where true wealth is made. Pullbacks happen, and when you are mired in bearish sentiment, these stocks will never return.
Remember: the S&P 500 has had an average annual growth of 10% for decades. Some of those years were losses, but if you are a long-term investor, you aren’t thinking about year-to-year performance.
What Changes Market Sentiment?
The number one thing that can quickly change market sentiment is an unforeseen global event. Usually, this means a market crash, but sometimes, it can also be a positive change. Remember the initial outbreak of the COVID-19 pandemic?
We saw the worst single-day drop for the markets in decades. The same thing happened after 9/11. Major global events can impact our feelings about the markets and the economy.
Other factors affecting market sentiment include macroeconomic factors like a rise or fall in interest rates. This will likely directly impact the stock market sentiment at some point in 2022.
Higher interest rates hit growth stocks as forward-looking revenue multiples are reduced. Government legislation, both domestic and international, can also affect market sentiment. Think about when cannabis or sports gambling was legalized in states.
Final Thoughts
Ultimately, market sentiment can be your friend when analyzing the market. If you know what other investors feel, you can predict that the stock will overshoot its intrinsic value. Likewise, if all you see is bearish sentiment for a stock, it will likely drop lower, allowing for a great entry point. Learn how to measure market sentiment and use it to your advantage when trading!
