How to Measure Market Sentiment
While the stock market’s eventual pricing is determined by fundamentals hour by hour, day to day, and week to week fluctuations are driven by market sentiment. The stock market always attempts to see the future. When the market as a whole thinks that stock prices are going up market sentiment is positive and when the sum total of traders and investors expect stocks to fall market sentiment is negative. Sentiment is driven by greed and fear. Here is how to measure market sentiment rather than simply trying to guess or read the tea leaves.
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Market Sentiment Indicators
As we always say, numbers don’t lie. There are several market sentiment indicators that will give you reliable indication of what the market as a whole is thinking about its direction.
VIX Fear Index
A commonly used indicator of sentiment is the VIX index. This measure looks at near term calls and puts as a way to decide if options traders are betting on the market going up or down. Because this index tends to jump up when the market becomes volatile it has the nickname fear index. We often trade the VIX as a way to profit from market fluctuations.
Safe Haven Assets
When long term investors expect to see a market decline or extreme volatility, they commonly rotate their investments out of growth stocks and into value stocks. Or they move out of stocks into short term Treasuries. In the Forex markets safe haven assets are generally the US dollar, euro, or yen. Options traders can profit by spotting moves in or out of safe haven assets.
Stock Price Breadth
Breadth indicators look at the numbers of retreating and advancing stocks and their volume. The point is to spot how many stocks are going up and how many are going down as opposed to looking only at the average of all stocks in an index like the S&P 500. This market sentiment indicator helps options traders spot emerging upward or downward trends as well as likely price reversals.
Risk On Assets
When traders and investors expect to see the market go into a bull run, they commonly buy riskier stocks or “assets.” A risk on indicator tells you that a shift into bull territory is likely. At this point a trader can swing into tactics that will benefit from the rise of riskier stocks. However, we strongly advise traders to continue to hedge their trades at all times.
CNN’s Fear and Greed Index
This market sentiment indicator looks at several factors from daily, weekly, monthly, and yearly views. The goal of the index is to assess if the market is fairly priced, driven too low by fear, or too high by greed. The index is derived from seven different sources and is scored on a zero to one hundred scale. Here are the seven constituents of the index.
- Stock price momentum measured by comparing the S&P 500 with its 125-day moving average.
- Stock price strength measured by how many stocks on the NYSE are hitting 52-week highs versus 52-week lows.
- Stock price breadth measuring trading volumes of declining versus rising stocks.
- Comparison of put versus call options similar to what the VIX does.
- Demand for junk bonds as a measure of risk-on strategies obtained by checking the spread between junk bonds and investment-grade bonds.
- Market volatility measured by taking a 50-day moving average of the VIX.
- The difference between returns on Treasuries versus stocks as a measure of safe haven demand.
Market sentiment indicators are useful in helping a trader anticipate market movements. While these can help guide your trading it is important to continue to hedge all trades. And, in uncertain markets like we are seeing today the best choice is not to trade alone. Consider joining one of the trading squadrons at Top Gun Options where we potentially print money no matter which way market sentiment is headed.
