Investors use both fundamental and technical analysis to develop a robust model that can accurately evaluate the performance of a company and determine its stock price. The goal of combining the two analysis is to know if the current price of the stock is different from the market sentiment and fundamental factors. If a difference is found, then there is an opportunity to invest.
Market Sentiment and Positioning
It is known that fundamental analysis is more useful for long term investment, and valuations are used to drive stock prices. The technical analysis on the hand is more suitable for focused and short term trading. The short term price movements are mostly driven by the supply and demand, and market sentiment that can help active traders to determine when to enter or exit a trade.
Market sentiment is a critical factor that can only be analyzed using price and volume data. The advancement in technology has already helped to effectively combine and test fundamental, technical, and quantitative analysis. As market sentiment analysis is still an evolving technique, algorithms are designed and developed to incorporate market sentiment and behavioral finance for more active trading strategies.
What Is Market Sentiment?
Market sentiment is a term that is used to express the prevailing trend of a financial market and the general feeling among the traders, and most importantly, indicate the direction of market prices. As a trader, market sentiment may help you understand the dynamics of the market and make you feel optimistic or pessimistic about the future value of stock or currency that you are trading.
The stock market can offer the maximum number of returns among all the other financial markets, but the critical factor is that the stock price moves in your favor. It is seen many times that a trader studies the trend lines and is convinced that the market will move in a particular direction and so invests but then ends up losing as the market moved in the opposite direction.
Market sentiment is the overall perception of the investors and quite apparent by price movements or
price trends of the assets that are traded in the market. A ‘Bullish’ trend suggests that the prices
are rising, while a ‘Bearish’ trend means that the prices are falling.
Understanding Market Sentiment
Market sentiment is commonly referred to as ‘investor sentiment,’ and it is not based on the fundamental factors. The active traders and technical analysts study the market sentiment as it considerably influences the factors and technical indicators and helps them measure and take advantage of short term price movements.
Market sentiment is also used by contrarian investors who like to take a risk and go against popular opinion in the market. For example, if the majority of the investors are buying, the contrarian investors would sell. Market sentiment is mostly viewed as part of technical analysis because it involves feelings, emotions, and trends, while fundamental analysis evaluates only business performance.
How Market Sentiment Affect Stock Market
The market psychology reflects the overall emotional state of the investors, and it is a combination of different contrasting feelings, and sentiments. For example, a Bullish or upward trend instills feelings of optimism, hopefulness, and gain, while a Bearish or downward trend may lead to despair, anxiety, and loss.
The short term markets such as a Stock market is usually driven on emotions, and investors are generally going through one psychological need or another. Greed and fear are the two most common emotional states for traders and can compel them to make decisions that are not rational.
For example, fear of missing out on a trading opportunity can make the investors pay to buy an asset that will not give them any profit; in this case, investors are buying an asset, not as a profitable investment, but just to avoid the feeling of missing out. Also, during Bearish trends, traders will sell stock at prices lower than the stock’s value so that they do not feel discomfort about losing money.
The Use of Indicators to Measure Market Sentiment
Investors look to make a profit by using stock that is undervalued or overvalued according to market sentiment. Investors can take help from various indicators that can measure the market sentiment and reveal which stock is profitable for trading. The commonly used sentiment indicators are High Low Index, CBOE Volatility Index (VIX), Moving Averages, and Bullish Percent Index (BPI).
- VIX Index
The most popular metric used to measure market sentiment is the VIX Index, also known as the CBOE Volatility Index, and it shows the volatility of index options. The VIX index is also called a fear index and is driven by options prices. Investors are looking to buy prospects to prevent loss and protect their portfolio. When investors predict an increase in volatility, they bid options at a higher price that causes the index to rise. Traders add moving averages to the VIX Index to know if volatility is high or low in the market.
- High Low Index
The High-Low Index is a comparison between number of stocks that remain high for 52 weeks to the number of shares that remain low for 52 weeks. When the index is above 70, it shows that stock prices are trading in a high position, and market sentiment signifies a Bullish trend. When the index is below 30, it shows that stock prices are trading in lows and market sentiment denotes a Bearish trend.
- Bullish Percent Index
The Bullish percent index (BPI) from the name suggests the number of stocks that are trading high, and the points and figure chart reveals a Bullish pattern. In most neutral markets, the BPI is estimated at around 50%. When BPI is 80% or more, the market sentiment is said to be very positive, and investors are optimistic, and stocks are overbought. Similarly, when BPI is 20% or below, it shows that market sentiment is quite negative, and stocks are oversold.
- Commitment of Traders
The Commitment of Traders or commonly known as COT is an outline or report that is published on every Friday of the week by Commodity Future Trading Commission (CFTC). The report shows both the net long and short positions of commercial and speculative traders. The report portrays the dynamics of the market and reveals how banks, hedge funds, and corporations are positioned according to Futures and Options. If the COT shows that many traders have shifted to Bearish attitude while there is a Bullish trend, then the market will see a change in the coming days. COT is mostly used to analyze the sentiment in Forex markets.
- Moving Averages
Moving averages are used to access if the market is about to go higher or lower. Investors use a 50-day, 100-day, or 200-day simple moving average (SMA). When 50 days SMA moves above the 200-day SMA, then it is called a Bullish sentiment. Likewise, if 50-day SMA moves below 500-day SMA, then it is called a Bearish sentiment.
- Put/Call Ratio
The Put/Call Ratio is a simple measuring tool that calculates the difference of Put options against the Call options being traded in the market. Investors usually buy Puts to safeguard their investments, a high Put options above 1 could mean investors are predicting the market to decline. Similarly, if the ratio falls below 1, this shows a high number of Call options, and investors think the market will rise.
The importance of market sentiment should not be underestimated as emotion and perception are two driving forces that shape both the Bullish and Bearish trend in the market. Investors can closely study the psychology of the market to predict the direction the market will take and trade accordingly to attain potential gains.
The information above is for education purposes only and cannot be considered as investment advice. Past performance is not reliable indicator of future results.
The Basic of CFD Trading
CFD trading course is designed to give you a firm foundation, enabling you to enter the CFD market with confidence and understand exactly what it takes to trade CFDs. Trading CFDs will require a lot of work on your behalf, and you will need to apply sensible and efficient risk management strategies.