Sentiment analysis is a type of study where traders focus on the mood of the financial market. For example, at times, loss-making companies do well in the market simply because investors expect them to become major players in the future.
Another example is where stocks rise when the Federal Reserve is hiking interest rates. This happens when analysts expect that the Fed will soon turn dovish.
We could provide hundreds of examples taking cues from the commodities world (with crude oil at the top of the list), but it would be superfluous.
The main thing is that you understand this: analyzing market sentiment is extremely important to make wise trades and avoid unpleasant trend changes.
Types of sentiments in the market
The two main types of sentiment in the market are: risk-on and risk-off. Risk-on sentiment refers to a situation where investors are prepared to take risks in the market. It is characterized by a strong performance in the stock and crypto market and a weaker US dollar.
Risk-off sentiment, on the other hand, refers to a situation where investors are afraid of risk. In this period, they turn defensive and embrace the so-called safe havens like value stocks and bonds.
What is a sentiment indicator?
A sentiment indicator is a tool that is used to measure the overall feeling or mood among investors and traders. The indicators look at several things, including social media posts, put and call options, safe haven demand, and media mentions among others.
These indicators differ from technical indicators in that they are not based on mathematical calculations. Instead, they are based on the mood in the market. Also, they are not based on a certain asset but the broad market.
Here are a few successful sentiment traders use to profit from the market.
Best market sentiment indicators
1. Social Media
Social media has changed how things are done today. Companies such as Facebook and Twitter are now very influential in the financial market. In fact, they are now more useful for traders than the traditional media channels such as Wall Street Journal and Financial Times.
This is why we made a post with the best account to follow on twitter.
In many times, the traditional media has been forced to write news after it broke in social media.
Another very important social media tool is StockTwits which is like Twitter but for the investment community.
As a sentiment trader, you need to constantly be on the lookout for what is happening in the social media. In 2013, a hacker hacked AP and reported that there was an explosion in White House and that the president was injured. This news led to a major market move in favour of the bears despite the fact that it was not true.
Therefore, as a trader, you need to look at social media before making any trading decision.
Related » Maximize returns with Social Media
2. CBOE Volatility Index
CBOE Volatility Index, also known as the VIX is one of the most important sentimental analysis tools. It is also known as the fear index. The VIX measures the amount of volatility in the financial market.
It accomplishes this by measuring the amount of investor protection within the next 30 days. For instance, if there is a major economic or financial news, chances are that the VIX figure will go up.
A good case in point happen during the Brexit vote. Before the vote, the VIX shot up from 15 to 20 in two trading days. In a normal situation, when there is such a move in the VIX, the result is that the S&P would move up by 3-4%. It moved by just 1.7%, which is an indication of the fear the investors had.
After the vote, the VIX was up to 25 which is an indication of the fear the investors had. Therefore, to be good at sentimental analysis, you should always refer to the VIX before making any entry or exit decision.
3. High/Low Sentiment Ratio
This is a very important tool that will help you make an informed trading decision. It is particularly important among traders who specialize on equities.
On a daily basis, a number of stocks will hit their 52-day high and lows. This indicator compares the number of stocks making their 52-day high and those making their 52-day low. If more stocks are in the high zone, it means that the market is bullish.
On the other hand, if more stocks are hitting their 52-day low, it means that the market is bearish.
As a sentiment trader, this information can help you make informed decision.
4. NYSE Bullish Percentage
As the name suggests, NBP measures the percentage of companies that have a bullish pattern in the New York Stocks Exchange (NYSE). This number is established by technical analysis on point and figure graphs.
Normally, the percentage is in the range of 40 and 60%. This is because in a normal market environment, there will always be companies that are doing well and others not doing well. When this number goes very high (>80%), it is an indication of an overbought market.
When it goes very low below 20%, it is an indication of an oversold market.
5. Fear and Greed Index
The fear and greed index is one of the most popular sentiment trackers in the financial market. The index, which was developed by CNN Money, is widely used to show whether there is fear and greed in the financial market.
It does this by looking at several aspects of the financial market. For example, it looks at the stock price strength, where it looks at the number of stocks hitting their 52-week highs. It also looks at the stock price breadth, using the McClellan Volume Summation index.
Other major constituents of the fear and greed index are the put and call options, market momentum, junk bond demand, market volatility, and safe haven demand.
The fear and greed index ranges between zero and 100. When it is close to zero, like it was during the 2020 stock market crash, it is usually a sign that the market is extremely fearful. A level close to 100 is a sign that the market is extremely greedy, and is often a sign to sell.
6. Buffett Indicator
Another popular type of sentiment measurement is the so-called Buffett indicator. It is usually associated with Warren Buffett, who is one of the best-known investors in the market. It is usually a ratio of the US stock market valuation compared to the total GDP.
As of this writing (end of 2020), the US has a total GDP of about $21 trillion while the total market cap of all public stocks is $45 trillion. This means that the Buffett indicator is 203%, which is 72% higher than the historical average.
The chart below shows the Nasdaq 100 index together with the Buffett Indicator.
Having a good understanding of market sentiment is an excellent thing for most traders. For example, knowing where the VIX is can tell you what to buy or sell. The same is true with other tools like the fear and greed index and the NYSE bullish percentage.
Before you use them, we recommend that you spend a few days in a demo account to see how they work.