Market Sentiment Indicators

The price move of any security is due in part to market sentiment. When there is little or no news about a security, then market sentiment may be the biggest factor in any price moves in the short run. Even when important news about a particular company or security is published, the resultant price moves are often enhanced or diminished by whether the market is bullish or bearish at that time.

There are many attempts to accurately gauge market sentiment and so there are many different kinds of sentiment indicators—only a few are presented here. While some sentiment indicators, such as volume indicators, can be used for individual securities, most market sentiment indicators are based on broad market data.

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Some older market indicators are based on the idea, right or wrong, that uninformed traders usually make the wrong decision, buying at market tops and selling at market bottoms. For example, an old sentiment indicator is based on odd-lot trading statistics, which measures the number of shares of stock being bought or sold in odd lots, which are less than the 100 shares composing a round lot. Based on the odd-lot theory that most of these buyers are presumed to have little money to trade and are, therefore, presumed to be the least sophisticated market players, and so they buy when the optimism has peaked, and they sell when pessimism has peaked and the market has bottomed out. Informed traders see odd-lot buying as a sell signal and odd-lot selling as a buy signal, so they do exactly opposite of what the uninformed traders are doing, which is why many of these sentiment indicators are also called contrarian indicators.

However, the odd-lot theory has not been a very good indicator, probably because most odd-lot buyers are not traders, but are buying for the long term and only when they have the money, and, thus, are not good indicators of market sentiment. Somewhat more reliable, since short sellers are traders, is the odd-lot short sale ratio, which is the number of odd-lot short sales divided by the number odd-lot sales. Presumably, a higher odd-lot short sale ratio indicates a market bottom.

Another sentiment indicator considered more reliable is the put/call volume ratio, which is the ratio of the total number of puts to the total number of calls traded in 1 day. A put is an option that increases in value if the underlying security decreases in value. So you would buy a put if you expected that the price of the underlying security was going to decline in the near future. A call is an option that increases in value as the underlying security increases in value, so you would buy a call if you expected the price of the underlying was expected to go up soon. The put/call volume ratio is a contrarian indicator, because it is generally at a maximum at market bottoms. Hence, it would seem that uninformed players buy puts when the market has already declined.

Another popular measure of market sentiment is market volatility, which is the amount that prices of an index or security at a particular time deviates from the mean price as measured over a specified time period. The greater the volatility, it is reasoned, the greater the anxiousness of the traders, and traders feel more anxious when the market is declining or at the bottom than when it is rising. Low volatility implies that the uninformed traders are complacent and therefore is a sell signal while high volatility is more frequent at market bottoms when uninformed traders are most pessimistic about the market. Here, the contrarian buys.

The most common volatility indicator is the CBOE Volatility Index (Symbol:VIX), which measures the implied volatility, rather than the historical volatility, of the S&P 500 index. Other measures of implied volatility include options for the NASDAQ Composite Index (VXN) and S&P 100 Index (VXO).

This graph clearly shows the relationship between implied volatility and market sentiment. Before September 2008, the S&P 500 Index was holding steady and the CBOE Volatility Index (VIX) was low. As the credit crisis deepened in September, 2008, the market declined substantially while VIX increased dramatically. Note that where the market is lowest, volatility is at a maximum.

Bloomberg.com: Investment Tools

http://www.bloomberg.com/apps/cbuilder?ticker1=VIX%3AIND

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Breadth Indicators

The breadth of the market is the number of securities participating in a market trend. Greater breadth helps to confirm either a bullish or bearish trend. Popular breadth indicators are the advance/decline ratio and the new highs/new lows ratio.

The advance/decline ratio is the number of advancing issues, which are stocks that closed higher today than in the previous trading session, divided by the number of declining issues, which is the number of stocks closing lower than in the previous trading session.

The new highs/new lows ratio is the number of issues reaching 52-week highs divided by the number reaching 52-week lows.

When the breadth indicators are moving in the same direction as the market, then this is considered a confirmation of the trend. A divergence of the breadth indicators and the market is a sign that the trend may be changing. A bullish divergence occurs at a market bottom when the number of declining issues or new-low issues is decreasing even if the index is still declining, whereas a bearish divergence occurs at a market top when the number of advancing issues or new-high issues is declining from previous trading sessions.

Volume Indicators

Since market sentiment is the sentiment of the masses, it makes sense that tracking volume could be useful in divining market sentiment or the sentiment about a particular security. One sensible way of tracking sentiment is by noting the volume on uptrends or downtrends. High volume serves as a confirmation of the trend. Price moves based on low volume have much less significance.

Volume spikes, where volume suddenly increases by 2 or more times the previous average, may indicate important news about a company or security, so it would be prudent to check the news. When price moves are based on important news, then a new trend may be forming or the current trend may be enhanced and prolonged.

Another volume indicator is the on-balance volume (OBV), which is the cumulative total where the volume is added on the days that the price closes higher and subtracting volume on the days when the price closed lower. Oftentimes, but not always, the OBV reaches a maximum a few days before the price peak, and reaches a minimum a few days before the price bottoms out. Hence, the OBV indicator detects accumulation by buyers or distribution by sellers. Accumulation is a buy signal, while distribution is a sell signal.

Some traders refine the volume data by considering by what percentage the high close or low close is away from the midpoint, which is calculated by adding the high price and low price for the day and dividing it by 2. Then the volume added or subtracted is adjusted by how much the day's close deviates from the midpoint.

Are Sentiment Indicators Accurate?

There are many sentiment indicators, and an almost infinite variety of ways of interpreting them. Any indicators should be used with other indicators and even fundamental analysis.

How well any of these indicators work is hard to measure, but these seemed to be well established and are often reported in the financial presses.