The Role of Market Sentiment in Technical Analysis

Market sentiment in technical analysis is a key factor that is often overlooked by average analysts. In fact, market sentiment can influence the effectiveness and efficiency of technical analysis.

So, what is market sentiment? What is the importance of sentiment analysis in trading? How to gauge market sentiment using various tools? And what are the techniques to make informed trading decisions using market analysis? Learn answers to these questions here in this detailed guide.

What is market sentiment in technical analysis?

Market sentiment is a key factor in technical analysis. All markets and types of assets draw particular attitudes or moods from investors. Market sentiment refers to the attitude or mood of investors. Various factors such as market rumors, political events, economic news, etc. influence market sentiment. We can say that the prevailing opinion of market participants makes it bearish, bullish, or neutral.

Understanding the importance of market sentiment in technical analysis

The importance of market sentiment in technical analysis cannot be underestimated. But the question is why market sentiment is important in technical analysis. Well, there are multiple reasons.

Firstly, market sentiment significantly influences the prices of stocks and securities. How so? It’s quite simple to understand. Bullish market sentiment attracts buyers and that increases demand. As high demand means high prices, prices begin to increase. Conversely, high supply accompanies declining prices. Moreover, such high demand or supply may lead to a self-reinforcing cycle which means more buying pressure may tempt more buyers and vice versa. As a result of that cycle, prices continue to increase or decrease.

Secondly, market sentiment also influences the way market participants interpret market news, events, and economic data. For instance, the positive attitude of investors leads them to interpret economic data positively. Therefore, they continue to buy and invest. Conversely, the negative attitude of investors leads them to interpret economic data negatively. Therefore, they may decide to stay out of investing and trading.

Thirdly, technical analysts also rely on the assumption that overall market trends reflect market sentiment. Similarly, price patterns offer valuable insights into market sentiment. For example, bullish market sentiment leads to prices rising. On the flip side, bearish market sentiment leads to declining prices.

However, market sentiment can also cause significant problems for analysts despite being useful. How so? Because it changes really quickly. For instance, new events or information may influence market sentiment in a short interval of time. Therefore, you must stay updated on market sentiment and adjust technical analysis accordingly.

Tools to gauge market sentiment in technical analysis

The following are some key indicators that help analysts gauge market sentiment.

The VIX

The VIX is among the most effective tools to measure market sentiment and volatility. There are multiple ways to assess market sentiment using this tool. For instance, high readings of the VIX indicate fear among market participants. Typically, a 30+ VIX reading indicates high fear and high volatility in the market. Similarly, sudden spikes in the VIX are signs of uncertainties and fear among market participants. Additionally, you can conduct historical comparisons of the VIX values to gain more insight into the prevailing sentiment among investors.

The High-Low Index

The High-Low Index is another powerful tool to gauge market sentiment. You can use it to analyze market sentiment over a specific time period such as one week, one month, and so on. It gives you the number of new highs and new lows during a specified time period. The High-Low Index’s reading above 50 indicates that more securities are making more highs than new lows. Conversely, a reading below 50 indicates that more securities are making more lows than new highs.

The Bullish Percent Index (BPI)

The Bullish Percent Index (BPI) is also an effective tool to gauge market sentiment in technical analysis. It gives you a percentage of stocks or securities with bullish patterns. A BPI percentage above 70 indicates overbought market conditions and that in turn predicts an upcoming correction. Whereas a BPI percentage below 30 indicates oversold market conditions and that in turn predicts an upcoming correction. However, values between 30 and 70 indicate a moderate market where nothing is overbought or oversold.

Trading strategies based on market sentiment

There are multiple trading strategies based on market sentiment. You can use market sentiment to your advantage using the following strategies.

1. Trading in tandem with prevailing market sentiment

Trading in tandem with prevailing market sentiment means following the market sentiment. For instance, if the overall market sentiment is bullish, traders look to ride upward trends in the market. In other words, it also means volume trading.

2. Trading against the prevailing market sentiment

It is the opposite of the previous strategy. There are traders who prefer to trade against prevailing market trends. For instance, during times of pessimism, traders find undervalued stocks or other financial instruments. They seek to invest and hold for the long term for substantial gains.

3. News-based trading strategies

News-based trading strategies are also among the effective market sentiment strategies. These strategies involve capitalizing on the impacts of market news and newly released data on market sentiment. For instance, traders may take a short position if they expect a major news event that will negatively affect the prices of a particular stock.

Concluding market sentiment in technical analysis

We can conclude that no one can overlook the importance of market sentiment in technical analysis. It is an important factor because it affects the market prices of financial instruments. You can capitalize on market sentiment to make informed trading decisions. However, it is important to gauge market sentiment. Fortunately, there are a few powerful tools that enable you to measure market sentiment with ease. However, it is also a fact that trading strategies based on market sentiment carry significant risks. This is because market sentiment can change really quickly and the market may move against your position. Therefore, conduct technical analysis properly and also manage risk when employing strategies based on market sentiment.