Smart decision-making is what calls the shots in investment because it leads to great financial success.
Technical analysis, therefore, represents one of the most important focuses for investors.
It is the study of historical price movements, chart patterns, and various financial indicators to predict future price trends.
The technical analysis field is vast, but knowing some of the important terms and concepts in it helps one make wise investment decisions.
Among them, “market sentiment” plays a particularly crucial role in influencing the prices of stocks, bonds, commodities, and other assets.
Market sentiment
What is it, how to measure it, and why this is the most important piece of information the investor wants?
Why understanding what causes this market sentiment stampede will be helpful for investors in making better decisions, at least prepare to perhaps predict potential price movements.
Some related technical terms used in financial analysis regarding market sentiment also are discussed along with a number of significant indicators and their importance.
What is Market Sentiment?
Market sentiment is the summation of feelings by investors towards any market or asset at any given time. More accurately, it refers to the prevailing market mood-whether bullish or bearish or neutral.
As such, the overall psyche of investors is market sentiment, and it gets highly influenced by many factors ranging from economic news, earnings, and major world events.
Market sentiment carries a lot of importance. It usually sets the price fluctuation for short intervals even though the actual value of any asset remains constant in the course of time.
There could be times when some derogatory coverage in the media regarding a particular company will terrorize the investors under the overall scenario, and thus the stock goes down.
In a similar way, favorable news for an organization with associated increased demand for a stock compels the share price of a stock high.
Though market sentiment is the results of rational or economic factors or emotional factors such as greed or fear and hence not entirely predictable, people use technical analysis to judge what the mood in the market has been or possibly will be before predicting price changes.
Role of Market Sentiment in Technical Analysis
Technical analysis is the examination of past data in the marketplace, mainly price and volume, so as to attempt to predict subsequent price movements.
One of the fundamental assumptions involved in technical analysis is that fundamental and sentimental elements are reflected completely in the asset’s price.
Technical analysts use the study of price patterns and trends and its indicators to gauge the prevailing market feeling and make suitable investment decisions to make the investment more profitable in the future.
Market sentiment is something that is involved in great part in technical analysis because it could give a few hints as regards the direction where prices might take off to head.
For instance, when market sentiment becomes exceedingly bullish, this may imply a sign of indicating that the price will go further up in at least a short run. The opposite could hold when market sentiment is bearish, thus pointing to falling prices.
One of the most difficult challenges of technical analysis is to interpret correctly in terms of market sentiment, which indeed can be quite unstable and volatile in response to new information.
Investors rely on a variety of tools and indicators that help measure the sentiment and predict the future price movements.
Technical Financial Analysis Key Terms Related to Market Sentiment
This is the understanding of the most important terms in technical financial analysis to recognize and interpret market sentiment. Below are some of the most important terms and indicators used by investors in gauging market sentiment:
1. Bullish and Bearish Trends
Bullish
Bullish market sentiments refer to when investors look to the future prospects of an asset or the market as being favorable.
Thus, in a bullish market, people expect general price rises and, consequently, invest more than sell.
Periods of economic growth or positive news are usually associated with periods of bullish sentiment.
Bearish
A bearish attitude is when the investor becomes negative regarding the prospects of an asset in the future or a certain market. Under a bearish market expectation, it is to reduce prices.
Selling and holding off from purchasing gain popularity under a bearish attitude.
There could be various reasons, such as the release of not-so-favorable economic statistics, bad earnings reports, and other world conditions that create uncertainty.
2. Indicators of Sentiment
These are the tools used to estimate the general emotional state of the market. By using such tools, it would be possible for investors to track the current sentiments and, subsequently, make judgment calls as to whether the market is overbought, over-sold, or about to turn.
There are a host of the following widely used indicators:
VIX, or Volatility Index
VIX measures volatility in a market and measures the nervousness of an investor.
In simple words, it shows future volatility in options for the S&P 500 index. An increasing VIX thus depicts rising uncertainty among investors along with fear, while a falling VIX means more stable and silent markets.
This index usually operates in the reverse direction of stock markets, therefore it usually runs in the positive direction when the direction of the stock market is going negative.
Put/Call Ratio
The put/call ratio is yet another sentiment indicator that considers the volume of put options as against call options.
A high ratio indicates a more bearish mentality since it is an increased purchasing of put options; conversely, a relatively low put/call ratio would tend to indicate more buying of calls which implies a bullish view.
Investor Sentiment Surveys Several have been created, that form a few that survey investor sentiment. AAII Sentiment Survey is the American Association of Individual Investors.
Few investors will utilize these in turn as quick guides to glance through and note market feeling, so to say in the collective individual investors’ mind.
Anything appearing like an overhang is good looking at the markets as too bullish or bear on the extreme the other way out from their viewpoint is considered one extreme either bulls or bears on markets.
3. Relative Strength Index (RSI)
Relative strength index is another popular technical tool that measures both the speed of price movements in addition to price changes. It is primarily used to detect overbought or oversold conditions, which may be seen as a change in sentiment.
The RSI is a scale ranging from 0 to 100. A reading above 70 means that an asset is overbought and indicates very high bullish sentiment towards it.
Below 30 means that an asset is being oversold and reflects extreme bearish sentiment.
RSI helps the investor know if the price is reversing or not; it gives an idea of how the market feels.
For instance, if the RSI shows that a stock is overbought, that could mean its bull sentiments making it go up are unsustainable and the price would correct downwards.
4. Moving Averages
The most common application of moving averages is the smoothing of the fluctuations in prices. It helps ascertain the direction of the market.
For instance, there is an average computation of the price of the asset for some period such as 50 days or 200 days.
Such moving averages help the investor assess the mood in the markets by ascertaining whether the asset is moving upward, downward, or sideways.
Simple Moving Average
This is a very simple version of the moving average that works by computing an average price by which an asset has closed over a given period. Using a SMA helps trace the general direction and trend within the market sentiment.
Exponential Moving Average (EMA)
EMA is more focused on the most recent prices; thus, it is much more sensitive to the shift in sentiment.
EMAs are primarily used within short-term trading systems with an objective of picking up any buy and sell signals corresponding to a possible shift in a market’s overall sentiment.
5. Candlestick Patterns
A candle stick pattern is basically a graphical description of the action of price through a given span of time. In that regard, every stick of the candle represents open close, high as well as the low prices with a specific interval of time in which the specific candle stick design may go to a series with a story-telling of a market’s sentiments unfolding.
Some common ones include:
Bullish engulfing
occurs when there exists a smaller candlestick that’s bearish but followed by an even larger one that is bullish. Therefore, this changes the downtrend to an uptrend; from fear into optimistic.
Bearish Engulfing
This pattern of bearish engulfing is just the opposite of the bull pattern above; it shows a reversal from a positive trend to a negative one. In other words, it reflects that the current change in sentiments turns pessimistic from optimistic.
Doji
That is the least among the three body candlesticks. Sometimes the small body presents indecision from the market and sometimes a new change of trend. Quite often, one finds a doji preceding to the reversal in a trend
Why Market Sentiment Matters for Investors
Market sentiment concerns investors because, even if nothing has changed with the underlying fundamentals, it may influence short-term price movements.
It allows an investor to gauge potential opportunities and risks and change the strategy accordingly.
This would make it relatively easy for the investor to recognize the dominant trends through the market sentiment and technical indicators.
Be it a bull or bear trend, the investor would be able to identify it in good time and make profitable trades or avoid losses that may arise from such a trend.
Entry and Exit Timing
Technical analysis along with interpretation of the sentiment in the market help investors to appropriately time entry and exit of a position. For instance, if the market is too bullish, it must be on the top, and one should sell.
When the market is highly bearish and the prices have declined too much, then they should buy.
This would entail risk management by sentiment analysis in which the investor identifies beginning to a trend wherein sentiment changed and can move correspondingly to adjust or hedge on declines.
For example, an observable development for bearishness will begin shrinking the position for equities and starting protective strategies through options in the market.
Contrarian Opportunities
There are also contrarian opportunities available. If the sentiment is too bullish or bearish, that in itself can be a signal that the market over-reacted. Contrarian investors can make good use of such overreaction in the markets.
Conclusion
Market sentiment works as an essential force in driving prices and as a mechanism that influences investments.
Technical analysis forms a source and a set of other tools and indicators so that the reader is able to estimate, measure, assess, and observe market sentiment, which may eventually lead to an informed position regarding price movements and the reversibility of markets in general.
Hence, most of the technical terms from bull and bear trends, sentiment indicators, such as RSI; moving average with a candlestick pattern, will help one make better-informed decision-making to be able to succeed in the game.
Although being fickle and hard to predict, vigilant analysis of indicators for such sentiment will help investors make better choices in the jumble of the market.
The inclusion of sentiment in technical analysis will ensure that investors learn better about the dynamics of the markets and can predict price movements in the short term and long term.
Summary
Market sentiment is a term used to define the general attitude that investors portray about a given market or an asset. The attitudes may either be bullish, bearish, or neutral.
This is an essential concept of technical analysis since it aids the investor in following up price trends with the overall psychology of the investors.
Using indicators such as VIX, RSI, moving averages, and candlestick patterns, investors assess the sentiment before making decisions regarding investment.
Through market sentiment analysis, investors become capable of identifying trends, timing of entry and exit, risk management, and finding contrarian opportunities. It impacts short-term price movements and could give insight to potential market reversals.
Frequently Asked Questions
What is market sentiment?
Market sentiment refers to the attitude of investors towards a market as a whole. It influences the price movements due to optimism or pessimism.
Why is market sentiment important for investors?
It helps the investor predict short-term price trends, identify buying/selling opportunities, and manage risk.
What tools measure market sentiment?
Most of the widely used tools are VIX or Volatility Index and RSI (Relative Strength Index) and moving averages.
How can sentiment lead to a price reversal?
Reminders of correction of the price is on extreme bullish or bearish sentiment since the situation is getting either overbought or oversold.
What is the difference between a bullish and bearish market?
Bullish is that the prices advance. When optimism is negative, then it is a bearish market.