Understanding market sentiment

Understanding market sentiment

In this article, we will look at what market sentiment is, why it is important, types of market sentiment, and indicators measuring market sentiment.

Market Sentiment Explained

Market sentiment defines the general attitude of investors toward a particular financial market or instrument. Rising prices are representative of bullish market sentiment while falling prices indicate a bearish market sentiment.

Now since we got the basic concepts out of the way, it’s time to move to more in-depth details.

Why is market sentiment crucial for the world of trading?

The market sentiment does not always rely on fundamental analysis (economic or political news). Technical analysts do not neglect it, as it can influence technical indicators used for capitalizing on price movements. Additionally, market sentiment can be popular at times amongst investors who prefer trading in the opposite direction of the general market consensus.

When trading, keep in mind that emotion can be a significant market driver. A financial market reflects the mix of feelings of everyone involved. At the end of the line, it shows what the majority feels is going to happen.

There is no way you can dictate how the markets should behave, but what you could do is trade according to what is happening to them—using the market sentiment approach and deciding for yourself if you want to go with the flow or not. However, you can combine the market sentiment strategy with technical and fundamental techniques and potentially discover even more trading ideas and possibilities. The sky is the limit!

Because we mentioned some indicators used to measure the market sentiment, let us take a closer look at some of the most popular ones.

Popular indicators used for measuring market sentiment

A. The VIX

The Volatility Index, or VIX, measures the volatility happening in the stock market. Generally, when VIX is at low levels, volatility is reduced, while a high VIX level translates to increased volatility. If you wish to learn more about how to approach volatile markets, check out our article here!

B. The High-Low Index

The high-low index is used to compare the number of stocks posting 52-week highs to the number of stocks posting 52-week lows. A High-low index below 30 shows that stock prices are trading near their lows, and investors might have a bearish market sentiment. When the index surpasses 70, stock prices are trading toward their highs, and investors might have a bullish market sentiment.

Typically, traders use this indicator in correlation with indices such as #USA500 or #TECH100.

C. Moving Averages

Moving Averages are indicators showing the median closing price of a market in a specific timeframe. Two of the most popular indicators falling into this category are the 50-day simple moving average (SMA) and 200-day SMA. If you checked our Market Overview section, you probably noticed how these are mentioned quite a lot.

When the 50-day SMA crosses above the 200-day SMA, it forms what the markets call a “golden cross” and might indicate that the trend could be experiencing a bullish sentiment.

When it sinks below the 200-day SMA, a "death cross" is formed, which the markets regard as low prices and bearish sentiment.

Market Sentiment and risk environment

When talking about a market sentiment environment, investors typically refer to risks, too, as they are an integral part of trading.

The Risk-on Risk-off investment setting

Risk-on risk-off characterizes the market sentiment where price behavior responds to and is driven by changes in investor risk tolerance. Essentially, it refers to the way people deal with their trading as a direct response to the economic and political events.

When investors perceive risk to be low, they tend to go for higher-risk investments to have a chance for equally significant returns. When the risk is high, investors generally move towards lower-risk investments. Lower risk-return environments can also indicate a capital preservation environment because investors tend to opt for a more cautious approach, rather than taking too many chances*.

*Source: investopedia.com.

The level of risk appetite rises and falls over time as economic conditions change, creating two different moods of risk on and risk-off:

The risk-on mood – chasing for bigger gains

A risk-on environment occurs when investors hunt for more substantial profits because at times some markets have suitable conditions for achieving that and the perceived risks are low.

In such scenarios, traders might look at currencies offering a higher interest rate yield or a potential higher price return on their money. Also, the stock markets of strong economies tend to do very well during risk-on trading, according to investopedia.com.

The risk-on sentiment can last for as little as minutes to many weeks, depending on how strong and intense it is, so experts recommend trading with the utmost care.

Risk-off – better safe than sorry

The risk-off sentiment occurs when the market perceives increased risks, causing investors to lay low and wait for better conditions.

During such times, investors fear volatility so they exit what they consider to be riskier trades that could enlarge their losses and move towards what are traditionally perceived to be safer currencies or assets, such as the JPY or the USD**.

**Source: investopedia.com.

When the markets move their attention to these currencies during risk-off times, the process is known as a safe-haven flow with U.S. Treasury bonds like Tbond30 or Tnote10 gaining popularity among investors.

Conclusion – the more you know, the better you can get

Much can be said about market sentiment and its crucial role in trading as we know it. To learn how to use these indicators, feel free to browse our short educational videos on CAPEX Academy!

Sources: investopedia.com, thebalance.com, fxstreet.com, babypips.com.

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