While trading psychology is often underestimated by traders, understanding the emotions and mental states that dictate investor behavior gives you a serious advantage as a trader. You can more easily understand market sentiment and how changes in the market mood can influence asset prices.
This is called “market sentiment analysis,” It can be used regardless of whether you’re focusing on Forex trading, share trading, or trading other markets.
Nowadays, let’s glimpse at how you can use market sentiment in your trading.
As it is the “dominating emotion/sentiment” that can best explain the market’s direction – where optimism = up and pessimism = down – you can use market sentiment to gauge what the market is feeling and if you should expect bullish or bearish market conditions.
Therefore, this sentiment-based approach will help you decide to go long (buy the market) or short (sell the market). You can also decide if you want to go with the flow or against it.
Evaluating market sentiment and incorporating it into your trading isn’t easy. To take advantage of trading opportunities based on changes in market sentiment, many traders rely on measures and tools combined with technical and fundamental analysis.
One of the most popular (and easy to understand) indicators to measure how markets feel is the trading volume that depicts the trading activity observed on a particular asset. Usually, if an asset price rises but trading volume starts to decline, it may signal that the market is weakening or overbought.
If an investment is falling but suddenly reverses with high volume, it might signal that the market mood has changed and is now strongly bullish/optimistic.
As transactions in the forex trading market are made over the counter, there is no centralized data on FX trading volume. However, traders can analyze Commitment of Traders reports from the US Commodity Futures Trading Commission to get an idea of the market dynamics (net long/short positions), as this report displays the holdings of different participants on the futures market, such as hedgers, financial institutions, significant speculators, and retail traders.
In addition to volume, volatility is another excellent measure of market sentiment. The Cboe Volatility Index (also called the VIX or fear index) is one of the most popular, measuring the implied volatility observed in options markets.
They are usually rising VIX signals that market participants are nervous and that markets might be more volatile, as traders might feel the need to protect their investment against upcoming risk and higher uncertainty. On the other hand, low volatility usually implies that the market mood is “stable” and that the trend should continue.
Another popular indicator used to gauge market sentiment on the stock market is the highs/lows ratio that compares how many stocks have hit their 52-week high or 52-week low. If the number of stocks that reached their 52-week high is greater than the one that hit their 52-week lows, then the sentiment is bullish – and vice-versa. This indicator is also often used to spot topping or bottoming situations, triggering a reversal.
Market sentiment can help you get a sense of the market mood, so then you can better predict its direction and get ahead of big moves. Of course, tracking market sentiment alone will not be enough to create a sound trading plan, but it can be an excellent addition to your trading strategy to help you make more informed trading decisions.
We’ve mentioned 4 of the most popular ways to gauge market sentiment – volume, VIX, CBOT, as well as high/low sentiment indicator. Still, there are other measures you can use like put/call ratio, bullish percent index (BPI), stocks above/below-moving averages, momentum, as well as market breadth. The most important thing is to find the right tool for your trading style and strategy.
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