The financial markets are guided by a multitude of factors ranging from economic to socio-political dynamics in participating countries. Another very important factor that drives the world markets is market sentiment; the psychological component of the markets. It accounts for a lot of unexplained phenomena in the global financial world. For example, why does a company’s stock plunge suddenly despite a healthy annual balance sheet or good dividend payouts? Why do the currency markets become volatile following the release of vital economic indicators?
Investor sentiment has a lot of say in the financial markets. The general attitude of investors guides their financial decision making; the sum total of which forms the overall market sentiment. In recent years, traders and researchers have identified the importance of tracking market sentiment to make informed trading decisions. This is why economists put stress on studying “behavioural finance.”
The overall attitude of traders or investors towards a particular financial asset or instrument is collectively termed as investor sentiment or market sentiment. Crowd psychology is reflected in the overall price activity of the financial asset. Rising currency prices point towards a bullish market sentiment, while falling prices reflect a bearish sentiment.
How a group of investors feel towards a certain market or economy is governed by various factors. This includes inflation rates, unemployment figures, natural disasters, technological issues or other political factors, such as a lack of confidence in a country-specific government. A country, whose economic and geo-political developments signal towards a strong economy, will see its currency valuation soaring, as investors will have more confidence in it. Less favourable economic indicators, for example a weaker job market, will make traders wary of investing in the domestic currency.
Day traders and technical analysts have developed tools to quantify investor sentiment. They use various sentiment indicators, along with technical indicators, to confirm trends and price levels. What is important to know is that market sentiment in itself cannot be a reliable indicator to make trading decisions; but only to confirm market movements.
By observing changes in market sentiment, investors try to judge whether a market is likely to be bullish or bearish. In the forex market, price actions should ideally reflect all available information, but this is true only in theory. This “Efficient Market Hypothesis” doesn’t hold true in the real markets, which is where sentiment indicators find their uses.
Short-term traders use these tools wisely to quickly get in and out of positions. Contrarian traders resort to them in order to take up positions on the opposite direction of the sentiment. Here are some tools that have been used by traders to gauge market sentiment.
The American Association of Individual Investors survey is one of the oldest surveys, released online every Thursday. It measures the percentage of investors who are bearish, bullish or neutral on the stock market on a short-term basis. Individuals participate in these polls on the AAII website on a weekly basis. On January 31, 2019, the AAII short-term outlook for stocks revealed a very neutral outlook; the highest in six months.
This report is released by the CFTC every Friday. It covers the commodity futures market and forex futures and options market. It offers information on what type of traders traded in the derivatives market, what positions they took (size of positions) and in which direction they took these positions over the course of one week. It is a vital market sentiment indicator for intermediate and long-term forex traders. The COT report further categorises different traders according to their trading discipline and gives an idea on how they fared in the current market scenario.
Several survey-based sentiment indices are released by governments and businesses across the world. These indices offer traders valuable insights into an economy or a financial market. Often, the higher than expected results in such surveys can improve the overall market sentiment. Some examples of such indices include:
There are several indicators that measure the overall degree of participation of traders in a financial market. The S&P 500 and DOW release such information for the benefit of traders. The advancing issues/declining issues ratio is a popular tool in this category. Stocks that reach higher prices than the previous day are advancing issues, while those that drop to lower prices are declining issues. The Volatility Index is another important breadth indicator.
The volatility index tool is popularly used by forex traders to measure implied volatility. Volatility, as we know, is the amount of movement of prices from the mean position to either extremes. Higher the implied volatility, greater is the fear among traders regarding a market.
VIX is also a popular contrarian indicator. Extremely high or low VIX values signal contrarian traders that it is the time to trade against the tide.
For a forex trader, an accurate assessment of trade volumes in any currency pair is important to gauge market sentiment. The MT4 Accelerator Pack has its own Sentiment Monitor tool that can accurately predict market sentiment, based on open positions. The tool shows the number of traders who are long or short on an asset. The app also shows the historic sentiment plotted against price movement. From the dashboard, a trader can see market sentiment for a variety of currency pairs, all at once.
Monitoring crowd behaviour is important in assessing the right points of entry and exit, irrespective of your trading style. The supply and demand ratios of various assets are always governed by psychology of market participants. However, it should be noted that these indicators mostly report on historical prices, so they don’t take into account any current market reversals. It is wise to have risk management tools at your disposal, to ensure protection against sudden market volatility.