Market Sentiment Analysis

Business

One of the many steps in trading is getting a pulse on the markets, or at least getting a pulse on the stock you are about to trade. Having the pulse, or being aware, or being vigilant, or however you want to put it, is what we refer to as market sentiment.

Investopedia.com defines it like this:

“What does market sentiment mean? The sentiment or tone of a market (i.e. crowd psychology). It is shown by the activity and price movement of securities. For example, rising prices would indicate a bullish market sentiment. A bearish market sentiment would be indicated by falling prices.”

Most people believe that gauging market sentiment is as easy as turning on CNBC and listening to the commentators in the morning, or watching Jim Cramer’s Mad Money show to see how he feels about what’s going on in the markets right now. markets. While neither is necessarily bad, there is much more to measuring market sentiment than just one person’s opinion. No news program or financial talking head should be taken for the all-knowing soothsayer about what the markets will or will not do.

Market sentiment goes a little further than simply rising or falling stock prices. It is also about trying to predict as accurately as possible in which direction the market is most likely to move in the future, in the short and long term. Always remember, “most likely”, not absolutely!

Market sentiment can be measured in several ways: 1) bid/sell ratios 2) VIX 3) technical indicators 4) news and general market conditions 5) common sense.

1. Reasons for sale/purchase

Put/call ratios are simply the number of put options being bought vs. the number of calls that are bought in the same stock or index in the same expiration month. It can be measured in short-term or long-term expectations. It gives the investor an idea of ​​what the rest of the market is thinking. If more people are placing sell orders on a short-term option than calls on the same short-term option, it is an indicator that short-term investors in that stock are thinking of a downtrend. The opposite is true if buy orders significantly outweigh sell orders.

The Chicago Board of Options Exchange posts bid/ask ratios on its website at the end of each trading week. The data needs to be viewed in context because it is a measure of what has already happened, but at the same time it gauges investor sentiment as they prepare for the upcoming trading week. A ratio of 1.0 means that the same number of calls and puts were traded in that trading week (remember, this is across all options traded, not just one index or stock). A ratio greater than 1.0 means more buy than buy orders and less than 1.0 means more buy than buy orders. But a ratio of 1.0 is not considered uniform or non-directional. Because most traders are more bullish by nature, an even ratio of buy and sell orders is actually considered more on the side of bearish sentiment and a ratio of .85-.90 is considered more balanced. This, of course, also means that an index below .85 (meaning for every buy order there are .85 sell orders) is what investors would consider bullish sentiment. The further below .85 the ratio goes (meaning buy orders strongly outnumber sell orders), the stronger the bullish sentiment. Conversely, the higher the ratio above 1.0, the more bearish the sentiment.

While the CBOE put/call ratio measures sentiment in the market as a whole, you can gauge investor sentiment on an individual stock simply by looking at a chain of options and examining the put/call ratio on that particular stock. A stock can have a short-term sentiment that is very bearish while having a long-term bullish outlook as in the figure below.

This will help you decide how you should play the stock yourself, but keep in mind that this is simply following the crowd. That in itself is not a bad thing, but your trading needs to be based on more than just following what others are doing. As with many individual components of trading, put this in the context of the bigger picture.

2.VIX

The ticker symbol for the Chicago Stock Exchange Options (CBOE) Volatility Index, which shows the 30-day market expectation of volatility, is VIX. It is constructed using the implied volatilities of a wide range of S&P 500 Index options. This volatility is intended to be forward-looking and is calculated from both call and put options. The VIX is a widely used measure of market risk and is often referred to as the “investor fear gauge.”

(From investopedia.com) Most of the time, when indices are down, the VIX is up because bear markets result in or help cause “fear.” (Notice that when the DOW Jones Industrial Average goes down, the VIX goes up.)

The VIX measures fear in the market and fear often means bears. The tricky thing about the VIX as a sentiment indicator is that it really just states the obvious. This is because the number you are seeing is an indicator of what happened that day and on a day when market indices are down 2%-4%, you simply expect the VIX to be high. Any value above 20 on the VIX means fear is relatively high and hedging your positions is not a bad idea.

The best way to read the VIX is to see if volatility is still very high after a bullish day in the market. This is often called diversion and can help you if you are undecided about a trade. For example, you might be thinking that after a strong bull day in the DOW, it’s time to repurchase some covered calls that are being used to hedge a long position in stocks, but a look at the VIX might give you pause if after that day bullish the VIX is still quite high. This means that despite a bullish day, fear is still prevalent in the market and waiting a day or two would be more prudent. Like other indicators, use the VIX as one measure of what’s going on in the market, but not the only one.

3. General Market Conditions

When you are looking at technical indicators like the 5/20 day EMA or the RSI or MACD to see if a stock is moving higher or lower, look at the same indicators in the indices. Never forget that even though the DOW Jones Industrial Average only measures the 30 largest companies in the US, 85% of all publicly traded companies follow suit. If the DOW offers bearish technicals, the company you are trading has an 85% chance of following. So if you’re trading a stock in the opposite direction of the general market, make sure you have a very good reason for doing so.

Too many times in my trading experience I have seen a company report big earnings, give a good guidance or outlook statement for the next quarter or even the next full year, and still not be able to overcome the momentum of a bear market. Stocks like AAPL, BA and CAT, despite being fundamentally sound large companies, are still very likely to follow what the rest of the market is doing.

4. World events

War; hurricanes; political strife – all of these things can have an effect on what the markets will do. While you don’t have to be a news junkie, you do need to pay attention to what’s going on around you and place your positions accordingly. News events will often only affect the short-term movement of a stock, but larger global events like the Iraq war can put a lot of pressure on the stock market.

A great example of political events affecting market sentiment is election time. When there is a real possibility of political powers changing hands, people can become very optimistic or very scared. No matter what your personal politics are, you just need to be aware that politics comes into play probably more often than we’d like. At the time of this writing, the 2010 midterm elections are only a few months away. The balance of power in the US House and Senate could possibly change from very liberal to divided or slightly conservative. Do not believe for a second that this potential change will not affect the markets. Will! Time will only tell what change may occur, but a change in the political landscape often brings a change in the financial landscape.

Today more than ever we are becoming a global economy. Recent news about the financial solvency of European countries is having a big effect on US markets. Reports on banking and finance in China can send our own markets up or down depending on how the news affects the average consumer or the US in general. It is more important than ever to keep an eye out for things that may affect US markets. “News rules” many days, weeks, and months in the stock market, so never lose touch with current events.

5. Common sense

You don’t always want to play follow the leader, but remember that volume moves the direction of the market. If all the fish swim against the current, you could be bold and move in the other direction, but in stocks and options, that kind of attitude is likely to end up in trouble.

Pay attention to everything and make sure you place trades that, if worst case scenario occurs, won’t blow up your portfolio. If you go into every position looking for the worst case scenario and have a plan that takes care of one trade gone wrong, you will come out ahead most of the time and be a very successful trader.

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