Market sentiment significantly affects option prices, reflecting investors’ emotions and market expectations. Tools such as the Volatility Index (VIX), put-call ratios, and sentiment surveys provide valuable insights. These indicators help traders assess market mood and make better-informed decisions by factoring in prevailing attitudes rather than relying solely on market data.
Different types of market sentiment
Let us examine why each type of market sentiment is significant for traders and investors.
Market sentiment is broadly classified into three categories – positive, neutral, and negative.
Positive Market Sentiment
This reflects investor confidence and optimism. Signs include:
Increased buying activity
Upward movement in stock prices
Economic and corporate expansion news
General enthusiasm across media and investor circles
Neutral Market Sentiment
This suggests indecision or a wait-and-watch approach. Indicators include:
Negative Market Sentiment
This shows pessimism and caution. Common traits are:
How to analyse market sentiment?
Market sentiment, the collective mood of investors towards a particular security or the overall market, is a crucial factor influencing asset prices. To effectively analyse market sentiment, several methods can be employed:
Financial reports analysis
Examining financial reports, such as earnings announcements and annual reports, provides valuable insights into a company’s performance and prospects. These documents often serve as catalysts for market reactions. By carefully analysing such reports, investors can gauge the potential impact on stock prices.
Social media sentiment analysis
Social media platforms have emerged as significant channels for investors to express opinions and share information. By monitoring social media sentiment surrounding specific companies or the broader market, it is possible to identify emerging trends and potential shifts in investor sentiment. A prevailing positive or negative sentiment can influence stock prices accordingly.
Market sentiment indicators
Numerous technical indicators are designed to measure market sentiment. These tools assist investors in identifying potential trading opportunities by gauging the overall market mood. By employing these indicators, traders can gain a better understanding of market direction and identify undervalued securities.
An example of market sentiment
The acquisition of Twitter by Elon Musk in October 2022 and the subsequent mass layoffs of approximately 3,700 employees had a profound impact on market sentiment. Negative media coverage and concerns among investors led to a significant decline in Tesla's share price, plummeting by 54%.
This case highlights the substantial influence of market sentiment on stock prices. While Tesla's underlying business model remained sound, investor confidence was eroded by Musk's actions. However, it is noteworthy that Tesla's share price eventually stabilised, demonstrating the dynamic nature of market sentiment.
How to Measure Market Sentiment?
To better assess the prevailing market sentiment and use it to create and execute trading strategies, you can rely on certain technical indicators. They include the following:
Volatility Index (VIX)
Known as the “fear index,” the VIX rises when traders seek protection from volatility. India VIX, used on NSE, is based on five variables: stock price, strike price, expiry, risk-free rate, and volatility. A VIX below 15 implies low volatility; above 35 signals high volatility.
High-Low Index
This indicator measures market strength by comparing the number of stocks at 52-week highs to the total listed stocks. A higher index indicates bullish sentiment; a lower or negative index reflects bearish conditions.
Market Breadth
Market breadth gauges overall direction by comparing advancing and declining stocks. A positive breadth indicates more stocks are rising than falling, suggesting bullish momentum. It is often calculated via the Advance-Decline ratio and volume data.
Momentum
Momentum shows how fast stock prices are rising or falling. When multiple stocks show upward momentum, the market is likely bullish. A common measure uses the difference between Nifty’s 30-day and 90-day exponential moving averages, relative to the 90-day average. Negative values indicate bearish trends.
Foreign Institutional Investors (FII)
FII flows significantly impact market sentiment. Heavy FII investments typically signal market confidence, while withdrawals may indicate caution. Their activity is tracked on the NSE and BSE websites.
Limitations of Market Sentiment Analysis
Market sentiment is an important indicator, but it is not the only metric that matters. Once you get a clear idea of the overall market mood, you need to also evaluate the prevailing sentiment surrounding the stocks or securities that you are interested in. This is because the overall market mood may be optimistic, while the stocks you are interested in may be falling.
So, it is essential to perform the required technical analysis or fundamental analysis for the specific stock or security. This will help you better understand how you need to plan your trades after accounting for the finer details of the stock-specific market sentiment.
Conclusion
Ultimately, market sentiment is an important factor to consider before you decide to make any move in the market — whether it is to enter a new trade or close an existing position. Even the target price and the stop-loss limits you set for a trade depend on the investor sentiment prevailing in the market.
However, it is equally important to remember that market sentiment alone is not enough to plan your trades. You must also factor in price patterns, technical intraday trading indicators, candlestick patterns and national and international elements before deciding to initiate or close a position.
