Understanding market sentiment can be a powerful tool for investors. Reading the mood of where the market is heading can allow you to capitalise from the changing direction. So, what is market sentiment and how do you trade it?
In the short run the market is a voting machine, but in the long run it is a weighing machine,’ – Benjamin Graham, renowned investor regarded as the father of value investing.
How do you feel about financial markets – do you think they will rise or fall in the future? If you can answer that question, then you already understand what your personal sentiment is toward financial markets, whether you trade stocks, foreign exchange or another security.
Financial markets are fuelled by emotion and this is one of the main reasons investors can find opportunities to trade. Take stocks for example, one of the key reasons share prices do not necessarily match the company’s book value is because investors are reading beyond the fundamentals of the business and pricing in their sentiment, which can be influenced by all manner of things.
This shows the importance and impact of sentiment on markets, but also highlights the need to blend it with other measures such as technical analysis or fundamental analysis.
Understanding market sentiment is one thing, but trading it is another. Evaluating market sentiment as part of your trading strategy is only worthwhile if you can use it to get ahead of the game and can make trades before the rest of the market. There is a big difference to how the market feels now and how it feels about the future, and only the latter provides investors with a trading opportunity. In simple terms, you have to use market sentiment to identify trends and join the bandwagon before it’s too late and you’re left trading securities as they top or bottom-out.
So, how do you track the sentiment toward markets and how do you trade it?
What is market sentiment?
Market sentiment represents the mood of financial markets and the general feeling among traders, whether they trade foreign exchange, the stock market or anything else. Understanding sentiment allows you to judge whether a market is feeling optimistic or pessimistic about the future of prices of a security, such as a stock or currency, for example.
If the market is feeling positive and optimistic about the outlook then this is referred to as bull market, and a pessimistic market that expects prices to fall is referred to as a bear market.
Gauging market sentiment, however, is tricky. Attitudes and the outlook of a market are both shaped by anything and everything, therefore investors need to spread a wide net to ensure they are informed as much as possible about the ever-evolving market they trade.
In addition, while the majority of the market will lean one way or another, every participant holds their own view on why the market is performing the way it is and where it is heading next. While the opinion of the majority often dictates the overall sentiment toward a market, there are the likes of contrarian investors who bet against the dominating sentiment – when the market is optimistic a contrarian will take a pessimistic view, for example.
Market sentiment is demonstrated through price movements of the security in question. If prices are on the rise, then this is indicative of a bullish market. Whereas prices on the decline point toward bearish sentiment.
Sentiment will differ depending on the market, and in some cases often correlate with one another. When bullish sentiment starts to surface in one market, bearish sentiment can emerge in another, or vice-versa.
Take safe-havens as an example, like gold. When equities are on the decline the price of gold is often on the rise, as investors look to plough their money into a commodity that can hold its value, rather than risking their capital on uncertain stock markets, before reversing when equities pick back-up as money shifts from one to the other. A large part of using market sentiment to trade is being able to read when a market is about to turn, which is where fear and greed come into play.
