What's Market Sentiment? How to Use Greed & Fear to Make Better Investing Decisions

By Chika

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Last Updated: May 10, 2022

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Gauging sentiment in the market is just as important as fundamental and technical analysis, if not more.

There are numerous cases where a company will have sound fundamentals and yet, its stock price would be down because investors do not like the stock. A stock may also hit oversold territory on the chart, yet its price would continue to rise, despite how investors feel towards the stock.

A good example of market sentiment is the huge spike in the buying of meme stocks, most of which had no fundamental story behind them, other than the likelihood of having a squeeze on short-sellers.

Market sentiment should play a key role in your risk analysis and due diligence because it can help to determine when to enter and exit positions. 

 

 

What is Market Sentiment?

Market sentiment refers to the overall attitude of investors toward a particular security or financial market. It is the feeling or tone of a market, or its crowd psychology, as revealed through the activity and price movement of the securities traded in that market.

In broad terms, rising prices indicate bullish market sentiment, while falling prices indicate bearish market sentiment

 

 

4 Technical Tools Investors Can Use to Gauge Market Sentiment 

1. Cboe Volatility Index (VIX)

VIX measures the level of implied volatility, (not historical or statistical), of a wide range of options, based on the S&P 500. This indicator is often referred to as the "fear gauge," because it reflects investors' best predictions of near-term market volatility or risk.

Other factors inclusive, in most cases, a high VIX reflects increased investor fear and a low VIX suggests complacency. This pattern in the relationship between the VIX and the behavior of the stock market has been observed in previous bull and bear cycles.

 

2. High/Low Indicator

The high-low index compares the number of stocks making 52-week highs to the number of stocks making 52-week lows. 

Stock prices are near their all-time lows when the index falls below 30. This means investors are bearish on the market. When the index rises over 70, stock prices are approaching their all-time highs, and investors are bullish on the market. 

The indicator is typically applied to a certain underlying index, such as the S&P 500, Nasdaq or NYSE. Contrarian investors might use this sentiment indicator to buy quality stocks during periods of severe pessimism.

 

3. Fear and Greed Index

The fear and greed index was developed by CNN to track investor sentiment based on two of the most significant emotions that impact how much investors are willing to pay for a stock within a given timeframe. 

The index may theoretically be used to determine if the stock market is priced fairly. This is founded on the notion that extreme fear tends to drive down stock values, while excessive greed tends to push up stock prices.

The CNN fear and greed index examines seven different factors to establish how much fear and greed there is in the market. These include:

  • Stock Price Momentum
  • Stock Price Strength
  • Put and Call Options
  • Stock Price Breadth
  • Junk Bond Demand
  • Market Volatility
  • Safe Haven Demand

Each of these seven indicators is measured on a scale from 0 to 100. The index is computed by taking an equal-weighted average of each of the indicators. The higher the reading, the greedier investors are, and vice versa. A reading of 50 is deemed neutral.

 

4. Put-Call Ratio

The put-call ratio is a metric used by investors to assess a market's overall sentiment.

  • A "put," (also referred to as a "put option,") is a right to sell an asset at a defined price.
  • A "call," (also referred to as a "call option,") is a right to purchase an asset at a defined price.

A surge in negative sentiment is signaled by traders buying more puts than calls. If they are purchasing more calls than puts, it indicates that they believe the market will continue to rise.

How to Be Fearful When Others Are Greedy: 5 Lessons From Warren Buffett

 

 

How to Use Greed and Fear to Make Better Investing Decisions

Knowledge of the sentimental indicators outlined above is unproductive if you cannot put it to use. Knowing when fear or greed is pervasive in the market can be put to profitable use. The extremes of these emotions are a signal to enter or exit the market.

For example, a value investor can take a position in a high quality dividend-paying stock when there is fear in the market because investors have dumped stocks. Likewise, you can sell a high-growth non dividend paying stock when there is much greed. This is because that's when investors are enthusiastic about getting into the market. 

Greed and fear can also foretell the direction of the market. For example, if you are noticing a steady increase in put ratio against calls, it could be an indication that bearish sentiment is growing among investors and a cue to get out.

In the same vein, an increase in buying junk bonds could indicate that investors are ready to take on more risk. This could lead to a bullish run. 

 

Key Takeaway on Market Sentiment

Investor sentiment is key in determining the possible price action of a stock or the market in general.

Tracking fear and greed can help make better decisions. Investors can take a contrarian view of the markets. This suggests buying when the rest of the herd appears fearful or selling if they’re greedy.

While it can be a useful tool to decide the timing of certain investments, it shouldn’t be used as the only determinant in investment decisions.

Photo by energepic.com

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