Traders and investors can rely on a wide range of indicators to assess market movement and anticipate future price changes. Many of these indicators are quantifiable. However, some, like market sentiment and investor mood, cannot be easily boxed into a number. Nevertheless, these abstract factors also greatly influence the price of stocks and securities in the financial market.
In this article, we help you understand the meaning of market sentiment, why it matters and how you can assess the prevailing mood in the market.
What is market sentiment?
Market sentiment, interchangeably referred to as investor sentiment, encapsulates the prevailing attitude or outlook of market participants toward a specific security or the broader financial market. The collective optimism or pessimism of investors is prominently reflected in prevailing price trends.
Like all outlooks in trading psychology, market sentiment can be positive (aka optimistic) or negative (aka pessimistic). Between these two extremes, we have neutral market sentiment that occurs when there is no strong emotional trend driving the prices in any specific direction.
The significance and impact of market sentiment
Market sentiment is often overlooked in favour of other indicators like technical tools, candlestick charts and price graph patterns. However, this can be a costly mistake because ignoring the market mood can set you back in your trades. You may make a wrong trading decision and lose a significant portion of your capital.
Different types of market sentiment
Let us examine why each type of market sentiment is significant for traders and investors.
1. Positive market sentiment
Positive market sentiment occurs when participants are optimistic about the economy in general and the market in particular. This kind of sentiment encourages people to invest more money in the markets. So, the buying activity increases, leading to rising prices and a potential bull run. Knowing when the investor sentiment is optimistic can, therefore, prepare you to initiate new long positions or close your existing short positions in the marketLet us examine why each type of market sentiment is significant for traders and investors.
2. Negative market sentiment
Economic uncertainties and negative global or local events may turn investor sentiment negative. Such a pessimistic market mood typically means people will tend to focus more on preserving their funds, leading to mass sellouts in the securities market. This results in disproportionately high supply when compared with demand, leading to a steep decline in prices. This is how a bearish phase begins in the market.
3. Neutral market sentiment
Between optimistic and pessimistic investor outlooks, there is a middle ground where market sentiment is neutral. This phase may be marked by price consolidation, which leads to a sideways market. You can consider trading strategies like swing trading. A neutral market sentiment may occasionally turn slightly positive or negative, which results in minor bullish or bearish market trends respectively. You can employ momentum trading in such periods.
How to analyse market sentiment?
Market sentiment, the collective mood of investors towards a particular security or the overall market, is a crucial factor influencing asset prices. To effectively analyse market sentiment, several methods can be employed:
Financial reports analysis
Examining financial reports, such as earnings announcements and annual reports, provides valuable insights into a company’s performance and prospects. These documents often serve as catalysts for market reactions. By carefully analysing such reports, investors can gauge the potential impact on stock prices.
Social media sentiment analysis
Social media platforms have emerged as significant channels for investors to express opinions and share information. By monitoring social media sentiment surrounding specific companies or the broader market, it is possible to identify emerging trends and potential shifts in investor sentiment. A prevailing positive or negative sentiment can influence stock prices accordingly.
Market sentiment indicators
Numerous technical indicators are designed to measure market sentiment. These tools assist investors in identifying potential trading opportunities by gauging the overall market mood. By employing these indicators, traders can gain a better understanding of market direction and identify undervalued securities.
An example of market sentiment
The acquisition of Twitter by Elon Musk in October 2022 and the subsequent mass layoffs of approximately 3,700 employees had a profound impact on market sentiment. Negative media coverage and concerns among investors led to a significant decline in Tesla's share price, plummeting by 54%.
This case highlights the substantial influence of market sentiment on stock prices. While Tesla's underlying business model remained sound, investor confidence was eroded by Musk's actions. However, it is noteworthy that Tesla's share price eventually stabilised, demonstrating the dynamic nature of market sentiment.
Indicators to evaluate market sentiment
To better assess the prevailing market sentiment and use it to create and execute trading strategies, you can rely on certain technical indicators. They include the following:
1. India VIX
India VIX is an index that helps determine the volatility in the markets. It is based on the prices of the Nifty index options. High India VIX values indicate rising volatility in the market. Depending on the direction of the move, you can assess if the market sentiment is bullish or bearish. The index value can indicate the strength of the market mood.
2. Market Mood Index (MMI)
This indicator can help you evaluate the market sentiment further. It is specifically designed to reflect the prevailing mood in the market and is expressed as a number from 0 to 100. MMI values below 50 signal a bearish investor sentiment, while values above 50 mean the market mood may be bullish.
3. Market breadth
The market breadth is a simple yet effective indicator to gauge market sentiment. It compares the number of stocks whose prices are increasing with the number of stocks whose prices are falling. A positive market breadth means the overall market mood is positive (and vice versa).
4. High-low index
This index can be calculated by comparing the number of stocks that hit their 52-week high in a given period with those that hit their 52-week low in the same period. Higher values of the index indicate bullish market sentiment as more companies are hitting their annual record highs (and vice versa).
5. Bullish Percent Index (BPI)
The Bullish Percent Index is a technical indicator that quantifies the proportion of securities within an index exhibiting bullish price patterns. A reading above 80% typically signifies a bullish market environment, while a reading below 20% indicates a bearish market trend.
6. Moving averages
Moving averages are technical indicators employed to assess price trends over specific timeframes. Commonly used periods include 50 and 200 days. A bullish crossover occurs when the shorter-term (50-day) moving average surpasses the longer-term (200-day) moving average, indicating potential upward momentum. Conversely, a bearish crossover signifies the opposite.
7. Put-Call ratio
The put-call ratio is a market sentiment indicator comparing the trading volume of put options to call options. A heightened ratio generally suggests prevailing bearish sentiment, while a lower ratio implies increased bullish optimism.
Limitations of relying solely on market sentiment
Market sentiment is an important indicator, but it is not the only metric that matters. Once you get a clear idea of the overall market mood, you need to also evaluate the prevailing sentiment surrounding the stocks or securities that you are interested in. This is because the overall market mood may be optimistic, while the stocks you are interested in may be falling.
So, it is essential to perform the required technical analysis or fundamental analysis for the specific stock or security. This will help you better understand how you need to plan your trades after accounting for the finer details of the stock-specific market sentiment.
Conclusion
Ultimately, market sentiment is an important factor to consider before you decide to make any move in the market — whether it is to enter a new trade or close an existing position. Even the target price and the stop-loss limits you set for a trade depend on the investor sentiment prevailing in the market.
However, it is equally important to remember that market sentiment alone is not enough to plan your trades. You must also factor in price patterns, technical intraday trading indicators, candlestick patterns and national and international elements before deciding to initiate or close a position.
