Most long-term investors focus on a company’s growth and valuation when making decisions. By contrast, most short-term traders are focused on emotion when buying and selling stocks. The effects of emotion can be seen in everything from long-term chart patterns to short-term order books. Sentiment indicators help gauge the market’s mood at any given point in time to put prices into context.
In this article, we’ll take a look at some common sentiment indicators and how traders can use the information to gain an edge in the market.
Be sure to also see the 10 Market Indicators Every Trader Watches.
There are many different ways to gauge the market’s sentiment, depending on the metrics measured to questions asked. For instance, the put-call ratio looks at the market’s expectations for the future based on options contracts, while many different surveys assess the market’s mood by asking questions. Traders should be aware of the major sentiment indicators and the direction they’re pointing.
The put-call ratio measures the volume of put options relative to the volume of call options traded over a period of time. When call options outpace put options, the ratio signals a bullish attitude in the market and vice versa. The key turning point for the ratio is 1.0x, where anything above that level is considered to be bearish and anything below that level is considered to be bullish.
Traders should keep an eye on both the ratio itself and trends in the ratio over time that could signal a reversal in trends. For example, a negative reading of 1.1x might be considered bearish unless a trader looked back and saw that the number actually moved down from a prior reading of 1.6×. In that case, the trader may take a bullish position in the market in anticipation of the trend continuing to reverse.
The American Association of Individual Investors (“AAII”) survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market over the next six months. With a weekly survey of AAII members (one vote per week per member), the poll provides a detailed picture of both short-term and long-term sentiment, as well as changes in the survey data over time.
As with the put-call ratio, traders should watch for changes over time in the AAII survey rather than individual readings in order to gain the greatest insights. Reading the actual surveys is self-explanatory with higher bullish percentages being more bullish for the market and vice versa. Traders can also access data going all the way back to 1987, which provides useful data for further analysis.
The National Association of Active Investment Managers Exposure Index represents the average exposure to U.S. equities reported by members. While the NAAIM warns that its index isn’t intended to predict future price movements, traders commonly use the index to gauge interest in equities over time. Managers also use the data to provide insight into the actual adjustments active risk managers are making.
In general, higher levels of equity participation indicate a bullish sentiment in the overall market. When equity participation starts to decline, it’s a sign that investment managers are starting to reduce portfolio risk, which could be due to a predicted decline in the market. As with the other sentiment indicators, traders should look at trends over time rather than any individual reading.
TD Ameritrade’s Investor Movement Index™ is a proprietary, behavior-based index designed to indicate the sentiment of retail investors’ portfolios by measuring what investors are actually doing. Using the data from a sample of 6 million funded client accounts, the index creates a valuable snapshot that can be monitored over time, compared to other indicators, and provide clues into current sentiment.
In general, increases in the IMX indicate that investors are becoming more bullish and vice versa for bearish scenarios. There are no bullish or bearish thresholds for the index, which means that traders should look at scores relative to other periods rather than analyzing a specific number. In addition to the indicator itself, TD Ameritrade provides an insightful commentary on changes in the index over time.
The CNNMoney Fear & Greed Index looks at stock price momentum, stock price strength, stock price breadth, put-call ratios, junk bond demand, market volatility, and safe-haven demand to calculate the level of fear or greed in the market. The idea is that too much fear can sink stocks below appropriate levels, while too much greed can send them far higher than they deserve to be based on valuation.
In addition to providing an overview of readings over time, CNNMoney provides a detailed analysis on each of the components of the index on an individual basis. Traders can look at these indicators separately or in aggregate, as well as analyze the trends over time. Readings over 50 suggest a greedier market, while readings below 50 suggest a more fearful market environment.
Using Sentiment Indicators
Traders should use sentiment indicators as a small part in a larger trading plan, which should include indicators and other forms of technical analysis. Often times, traders will use sentiment indicators to determine the direction of trades and then use technical indicators or chart patterns to identify specific entry and exit points for their trades in order to increase the overall probability of success.
Be sure to also read the 7 Rules Every Contrarian Investor Must Follow.
The Bottom Line
Sentiment indicators help traders quantify the market’s overall emotion and sentiment. Using these indicators, traders can get a sense of overall market direction, while using other technical indicators to identify specific entry and exit points for trades.
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