When watching stock charts it’s tempting to think of the market as a logical, numbers-based phenomenon, especially if you’re a technical trader. But the fact is, the market is emotion-driven all the way. Even Benjamin Graham, the father of value investing, said: “In the short run, the market is a voting machine.”
Market sentiment is just another word for the mood of the market, its overall emotional outlook—that the market is fueled by emotion is the main reason you have opportunities to trade. A stock price is rarely reflective of its fundamentals, but more a reflection of the market’s emotions, or sentiments, about it.
Market sentiment isn’t monolithic, either. Even in an overall bullish market, there will always be bearish sectors. When equities decline, precious metals, especially gold, will invariably rise. Money flows into “safe haven” investments or currencies is an obvious sign of bearish market sentiment.
Once the market begins to move, one of two trading emotions come into play: Fear and greed. If you can spot their emergence, you have the potential for profitable trades. For example, if XYZ has been trading between $50 and $53 for a time, and, after breaking through resistance a few times, it breaks out significantly, greed may be taking over. Conversely, if XYZ tests support and then breaks through, falling precipitously, fear has entered the market.
There are several market sentiment indicators to incorporate into your trading strategy, but volume is perhaps the most obvious sign of market interest. If the price of XYZ is rising, but volume is falling, sentiment is weakening. Similarly, when the stock is under accumulation with high volume spikes on up days, institutional money is likely flowing in, suggesting strengthening sentiment.
The accumulation distribution line is a good indicator for this. ADL measures supply and demand by charting money flow volume. Assuming volume does predict a reversal in price, an ADL divergence suggests trading opportunities. When ADL trends upward indicating buying pressure, but price is trending downward, a bullish divergence, the price is poised to reverse.
The volatility index, or VIX, is another good indicator of market sentiment—there’s a reason it’s called the fear index. VIX tracks implied volatility in the options market, making it a good counterpoint to lagging indicators. Since options are typically hedging instruments, high volatility in the options market suggests fear that current market trends will reverse. Low volatility implies confidence that current trends will continue.
Although market sentiment can provide useful insight to confirm trading signals, it should not form the basis of your trading strategy. It shouldn’t be ignored or underestimated—emotion is a powerful thing in the market—but neither should it have an outsized impact on your trading decisions. Use it to give you a more complete view of the market and context for your trades.