Investing & Trading

Market Sentiment Indicator

By Samantha Baltodano


TL;DR:

Market Sentiment is a technical indicator that estimates the underlying mood or feeling of investors about a particular security or market as a whole. It measures the relationship of an asset's close price to its historical highs and lows. 


Higher values indicate bullish sentiment, lower values indicate bearish sentiment, and neutral values indicate neutral sentiment. Market sentiment readings can act as a trend reversal signal and when they're unusually high or low, they can change soon. 



What Is The Market Sentiment Study?

Market Sentiment is a technical indicator that estimates the underlying market sentiment based on the relationship of an asset’s recent close prices to the historical highs and lows for that asset.


You may be asking yourself, “what is a sentiment indicator?”


Well, a sentiment indicator by design represents the overall attitude or feeling of investors about a particular security or market as a whole. Sentiment indicators look at bullish or bearish traders and what they are thinking and feeling, which may help forecast traders’ future behavior. 


An example of market sentiment could be a widespread belief among investors that the stock market is going to experience significant growth, leading to increased buying activity and higher stock prices. Conversely, if investors are feeling bearish or uncertain about the market, they may sell off their stocks, causing prices to drop. 


These market psychology-based indicators attempt to quantify sentiment, in the form of figures or graphically, to predict how current beliefs and positions may affect future market behavior.



Interpreting The Market Sentiment Indicator

Higher indicator values signify that a bullish sentiment is currently prevailing. Lower indicator values suggest that the sentiment is currently on the bearish side. This indicator can also detect neutral market sentiments (the absence of dominating tendency).


The Market Sentiment Indicator may also indicate a trend reversal signal.


When market sentiment readings are unusually high or low, they may begin acting in a contrarian way. In other words, it means that current market sentiments may change soon. 


For example, when investors are extremely bearish (very low MSI values), that is often a contrary signal to sentiment indicator traders that market prices could start heading higher soon. Conversely, when investors are extremely bullish (very high MSI values), that is often a signal that market prices could start heading lower soon.



Structure Of The Indicator

The MSI consists of the following elements:


  • Histogram of market sentiments – is presented with 3 color gammas: blue color (bullish sentiments are dominating), red color (bearish sentiments are dominating), green color (neutral sentiments are present in the market),
  • Red zone – bullish extreme zone, warns that the current upward trend is ready for correction. Entering this zone is a signal for partial profit fixation for long positions;
  • Blue zone – bearish extreme zone, warns that current downward trend is ready for correction. Entering this zone is a signal for partial profit fixation for short positions.


 

Source: TradingView
Figure 1: Graphical structure of the MSI


Limitations of Using a Sentiment Indicator

Sentiment indicators are not timing signals. An extreme reading on the Commitment of Traders report doesn't mean the price of the asset will immediately reverse. Extreme reading can remain in place for a long time, or the price may stay where it is while traders unwind their positions and the extreme reading disappears without a significant price reversal.


Sentiment indicators are best used in conjunction with other forms of technical and fundamental analysis to help confirm market or economic turning points. 


For example, an extremely bullish sentiment reading, coupled with an extremely high price/earnings ratio (or deteriorating fundamentals), as well as a breakdown in price, provides more conclusive evidence of an impending downtrend than acting on sentiment alone.



Test The Market Sentiment Study

Great news! 


You can back test this exact strategy on historical data for any of your favorite symbols using TradingView. 


This strategy has already been built and all you have to do is log in and take it for a spin. You can access this indicator here.


If you’re new to back testing and to TradingView, don’t worry. I created a step-by-step guide you can follow to begin testing the Market Sentiment Study.



Summary

  • Sentiment indicators gauge market psychology in the form of investor or consumer behavior and beliefs that may influence the market.
  • When a sentiment indicator is moving in the same direction as what it is analyzing, that typically helps confirm that trend.
  • Extreme readings on a sentiment indicator may cause some traders to take a contrarian view; for example, "buy when there is fear, sell when there is greed."
  • Sentiment indicators are used to analyze trends, assets, and the economy from the perspective of the participants involved, instead of just looking at an asset or data point isolation.

Market Sentiment is just one of many studies that Archaide automates. For a full list of strategies and studies available click here.


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