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How to Use Market Sentiment

Is there a way to measure market sentiment, and if there is, what is the best way to use it?  The answer to the first question is yes, and the answer to the second is that there are several.  Sentiment reflects the confidence investors have in a market.  In general, robust sentiment is positive and subdued sentiment is negative, but when sentiment becomes exaggerated, and markets become frothy, confidence measures can be used as a contrarian indicator. The same can be said when complacency sets in.

Measuring Emotions

Measuring the emotions of fear and greed is one of the best ways to measure sentiment.  When fear is prevalent, investors are reducing risk, and are running for cover.  When greed is overwhelming, investors are increasing risk and tossing caution into the wind.

Using the VIX

One mechanism you can use to measure sentiment is option premium levels.  When investors are fearful that a security will tumble, they will purchase protection.  When they are complacent, the value of protection will decline. One of the best ways to measure the value of protection is to analyze a volatility index such as the VIX. When implied volatility is very high, and the VIX is elevated, traders are often fearful, and when volatility is depressed, and the VIX is low, complacency is prevalent.

Put Call Ratios

Another option mechanism that you can use is the put versus call ratio.  A put is the right but not the obligation to sell or short a security at a specific price on or before a certain date.  A call option is the right but not the obligation to purchase a security at a certain price on a designation date. If the open interest of puts is greater than the open interest of calls by more than 20%, sentiment is generally considered bearish and could reverse.  If on the other hand the open interest of calls is greater than the open interest of puts by 20%, investors might be considered overconfident.

Using the RSI

There are some technical analysis indicators that can be used to measure sentiment.  One of the most popular is the relative strength index. The RSI measures sentiment related to price action, and the relative level of the current price, compared to levels seen over a 3-week trading period if you are evaluating a daily chart.  The RSI can be used in any period, including intra-day, daily, weekly, monthly, etc. When the relative strength index has a value that is above 70, prices of the security that you are analyzing are considered overbought.  When the index value is below 30, prices are considered oversold.

It is important to understand that sentiment can remain overconfident or depressed for an extended period, which means that you need to be careful if you are trying to trade a contrarian view.  Markets usually reverse course when sentiment is extreme and there is an impetus for a change.  By adding market sentiment to your trading arsenal, you can prepare for a sharp change, when sentiment is exaggerated or subdued.

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