Understanding the Impact of Market Sentiment in Trading

Market sentiment in trading describes the behaviour of the investors and traders towards a particular market or asset. As simple as it sounds that is not all there is to it. On a much deeper level, it plays a role in the direction of a trade by shaping the decisions taken by investors and traders.

Market sentiment is essentially a reflection of the overall attitude and psychology of investors towards a particular market or asset. Therefore, it has a serious effect on the supply and demand dynamics in a trade, and by extension, affects the direction of the trade. As such, it is essential for every trader to understand what market sentiment is because it is the key to taking informed trading decisions. As an investor, market sentiment can help you measure how other investors feel about a particular market, which can help you predict the direction of the price.

In this blog post, we will explore market sentiment, the types and see the impact it has on trading.
Let’s dive in.

What is market sentiment?

Market sentiment refers to the collective emotions, attitude and opinions of investors, traders and market analysts regarding a financial market or asset. Basically, it is a measure of how bearish or bullish the market is.

It is influenced by factors such as economic indicators, news events and social media.

Types of market sentiment

Market sentiment is broadly classified into two categories. These include:

• Bullish sentiment: This market sentiment indicates that investors and traders alike are positive about the financial market and are expecting prices to rise. It is often characterised by an increase in the purchase of assets, rising prices and high trading volumes.
• Bearish sentiment: A bearish sentiment indicates that investors and traders are moving in a negative direction regarding the financial market, therefore prices are expected to fall. It is often characterised by increased selling activity, dropping prices and low trading volumes.

Spotting the type of sentiment is often tricky especially for a new trader or investor. However, there are indicators that can assist you in spotting the current market sentiment, thus giving you a clue on where the market is heading.

Types of market sentiment indicators

Market sentiment indicators are tools that traders use to gauge the market sentiment towards a financial market or asset. These indicators are essential because they help traders take informed decisions when making a trade in order to maximise returns and minimise risks. The types of market sentiment indicators include:

Volatility index (VIX)

The volatility index is also known as the “fear index”. It is a widely known market sentiment indicator that measures the expected volatility of the S&P 500 index.

High VIX levels show high expected volatility, which is a signal of a market bottom. A low VIX level shows low expected volatility which shows market complacency and is a clue that a market may have peaked.

Put/Call Ratio (PCR)

This is a market sentiment indicator that measures the ratio of put options to call options. When more put options are traded than call options, it is a signal of a bearish sentiment.

High-Low Index

The high-low index compares the number of stocks hitting 52-week highs versus those hitting 52-week lows.
Typically, when the index is less than 30, it means that the assets are trading near their lows and the market sentiment is bearish. On the other hand, when the index is greater than 70, the assets are trading near their highs which indicates a bullish sentiment.

Moving averages (MA)

It measures the difference between two moving averages. By doing so, it allows traders to identify the overall direction of an asset.
Most investors use a short-term MA (such as the 50-day MA) and a long-term MA (such as the 200 day MA) to determine the sentiment of a market. When a short-term MA crosses above the long-term MA, it is called a “golden cross” which indicates the possibility of a long-term bullish sentiment. Otherwise when the short-term MA crosses below the long-term MA. It is also called a “death cross” and is an indicator of a bearish sentiment.

The impact of market sentiment on trading

These are the major ways market sentiment influences the direction of a trade.

1. Price movements: market sentiments determine whether a financial market will be bullish or bearish. Bullish sentiments lead to rising prices and bullish sentiment leading to falling prices.
2. Trading volumes: good market sentiments lead to increased trading volumes while poor sentiments lead to decreased trading volumes.
3. Market volatility: positive market sentiments from investors (bullish sentiment) leads to lower volatility while negative market sentiment from investors (bearish sentiment) triggers selling pressure and higher volatility.

Conclusion

Market sentiment controls the trading decisions and eventually, the outcome of the financial market at the end of the day. Therefore, a good understanding of this concept is necessary for investors and traders in order to help them maximize their profit and manage risks better. Additionally, using sentiment indicators gives the participants of a financial market an edge as they give accurate data which helps to point in the direction of a market. By doing so, traders and investors can make informed decisions backed up by data before making a trade.

For more tips and guidance, visit our WEBSITE today!