The daily fluctuation in the price of financial assets is generated by market sentiment. As traders jockey for position, the price of an asset will swing, providing traders with opportunities to capture profits. Over the long term, price movements are dictated by supply and demand, but over the short-term price action is ruled by market sentiment.
What is Sentiment?
Market sentiment is a measure of emotion. Market sentiment describes the underlying feeling investors have toward a specific financial market or individual security. This attitude generates a market psychology which can generate price action within the securities traded in a market. In general, rising stock or bond prices indicate a bullish market psychology while falling prices indicator bearish market psychology.
Market sentiment will influence the daily changes in prices which produce the movements that are captured by technical analysis indicators. Sentiment can help traders judge whether bullish or bearish momentum will perpetuate or reverse. Market sentiment is an important component to contrarian investors who like to trade in the opposite direction of the prevailing trend.
How to Measure Market Sentiment
There are several ways to evaluate market sentiment. You can measure complacency and fear using a volatility index like the VIX, you can also use a technical index such as the relative strength index. You can also measure the number of speculators that are long or short a futures contract, which is published by oversight groups.
What is the VIX?
The VIX volatility index is a gauge of market sentiment as it measures the implied volatility of the “at the money” strike prices of the S&P 500 index. When investors are complacent, and stock prices are rising, the VIX generally declines. When investors become fearful of an adverse market change, the VIX begins to rise as investors look to hedge their exposure using options. The VIX is often used as a contrarian market indicator. When the VIX surges contrarian investors look to buy stocks. When the VIX drops to subdued levels, some investors look to short stocks.
What is the Relative Strength Index?
The relative strength index (RSI) is a momentum oscillator that describes the rate of change via an index. You can view the RSI on your brokers trading platform. It is also used as a sentiment index that foreshadows when prices have risen too quickly or declined too sharply. The RSI measures the rate of change of the price of an asset over the prior 14-days and generates and index between 1-100. Levels above 70 are considered overbought and reflects that sentiment is rising too fast. Levels below 30 are considered oversold and show that sentiment is declining too quickly.
What is the Commitment of Traders Report?
The Commitment of Traders Report (COT) is released weekly by the Commodity Futures Trading Commission. This report breaks down who is long and short specific futures contracts. Since most of the speculative positions are held by managed money, you can use this distinction as a contrarian indicator. When managed money is very long or very short, you can determine that sentiment is too positive or too negative. By using a combination of the VIX, the RSI and the COT report you can generate a gauge of market sentiment.
