Do you know how to measure market sentiment? Market sentiment is a fairly easy concept to define: it is the overall attitude and tone of investors. Defining it is easy, but measuring it and taking advantage of it is a whole other 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.
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What Is Market Sentiment
Did the above description make sense? It’s easy to get dissuaded and feel 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 a wide variety of 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 take a look at how exactly you can measure the current market sentiment!
How to Measure Market Sentiment
Do you know how to measure market sentiment? There are a lot of ways to accurately measure market sentiment. The easiest way is to just simply take a look at the markets over a set period of time to see how it behaves. 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 come to the conclusion that the market sentiment is overall bearish. Bullish bounces happen in the midst of bearish downtrends, and vice versa.
Market sentiment should always be measured against different time frames. Sentiments can change over the course of a year, a quarter, a month, a week, and even during the course of a single trading session.
How to Measure Market Sentiment: 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.
How to Measure Market Sentiment: The VIX
What is the VIX? It is more commonly referred to as the Volatility Index or Fear Index. The VIX was started by the CBOE or Chicago Board Options Exchange in 1993. It is a measure of the implied volatility and is derived from the price of S&P 500 options contracts.
The theory is that as these option premiums change, we get a clearer picture of market volatility and sentiment. The more volatile the market is, generally, the more bearish the sentiment is.
The VIX measures a 30-day, forward-looking window of volatility, so it is an excellent mechanism for measuring future sentiment. So if you’re learning how to measure market sentiment, then you know the VIX is a go to tool.
Social Media Sentiment
Did you know you can use social media when figuring out how to measure market sentiment?
Yes, social media sentiment is definitely a thing now. Even before the Reddit short squeeze from 2021, social media platforms like Twitter were playing a major role in shaping market sentiment.
Fintwit and Reddit are two excellent gauges as to what stocks or cryptocurrencies people are talking about. 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 ticker 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. There are plenty of people on Fintwit and Reddit who will pump or push down a stock for their own personal 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 as another gauge of how investors are feeling. Some savvy traders will even trade against this sentiment, especially when sentiment becomes overly bearish or bullish in either direction.
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.
How to Measure Market Sentiment With Fundamental Analysis
What is fundamental analysis? It is a look into how the company is affected by both 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 fair market value of the stock.
You can use fundamental analysis to forecast a stock’s performance. Things like earnings calls, new product launches, or even changes in management all 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. In fact, when learning how to measure market sentiment, you can use fundamental analysis.
Technical Analysis
Technical analysis is popular amongst traders and is the study of stock charts and past performance. By using previous support and resistance zones, technical analysts believe they can predict when and where a stock will trade. Technical analysis is especially useful for day traders or swing traders since they can use it to time an entry or exit.
How do you use technical analysis to determine market sentiment? There are certain technical indicators that 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 or relative strength index, or the MACD or Moving Average Convergence Divergence.
These follow the stock’s price action, as well as 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.
Which Market Sentiment is Better: Bullish or Bearish?
It really 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 type of 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, then you can hedge with some puts on the stocks you own or even on the S&P 500 index.
In the grand scheme of things, investors just feel psychologically better when the market sentiment is bullish. 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 take a 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 it seems like these stocks will never go back up.
Always remember: the S&P 500 has had an average annual growth of 10% for decades now. 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 be a positive change as well. 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 have an impact on how we feel about the markets and the economy overall.
Other things that can affect market sentiment include macroeconomic factors like a rise or fall in interest rates. This is something that will likely have a direct impact on 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.
Bottom Line
In the end, market sentiment can be your friend when analyzing the market. If you know what other investors are feeling, you can predict that the stock will overshoot its intrinsic value. Likewise, if all you see 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!
