Market sentiment is the collective psychology of market participants. Tracking it helps you spot turning points and avoid crowded trades.
Sentiment Basics
Sentiment breaks down into three states:
- Bullish sentiment: Optimism, risk-taking, buying pressure
- Bearish sentiment: Pessimism, fear, selling pressure
- Neutral sentiment: Uncertainty, consolidation
Extreme readings in either direction often precede reversals.
Contrarian vs. Confirmation
Contrarian Signals
Extreme sentiment marks turning points:
- Maximum bullishness = potential top
- Maximum bearishness = potential bottom
- The crowd is often wrong at extremes
Confirmation Signals
Moderate sentiment confirms trends:
- Rising bullishness in uptrends
- Rising bearishness in downtrends
- Sentiment aligning with price
Indicators Worth Tracking
VIX (Fear Index)
Measures: Expected S&P 500 volatility from options prices
Reading it:
- Low VIX (under 15): Complacency, potential top
- Normal VIX (15-25): Neutral conditions
- High VIX (over 30): Fear, potential bottom
Trading use: Extreme VIX readings often mark turning points
Put/Call Ratio
Measures: Ratio of put options to call options traded
Reading it:
- Low ratio (under 0.7): Too many calls, bullish extreme
- Normal ratio (0.7-1.0): Balanced
- High ratio (over 1.2): Too many puts, bearish extreme
Trading use: Extreme readings suggest potential reversals
AAII Sentiment Survey
Measures: Weekly poll of individual investor sentiment
Reading it:
- Bullish above 50%: Extreme optimism
- Bearish above 50%: Extreme pessimism
- Spread (Bull - Bear): Extreme readings matter
Trading use: Contrarian indicator; extreme readings are often wrong
CNN Fear and Greed Index
Measures: Composite of 7 sentiment indicators
Scale: 0 (Extreme Fear) to 100 (Extreme Greed)
Reading it:
- 0-25: Extreme Fear, potential buying opportunity
- 25-45: Fear
- 45-55: Neutral
- 55-75: Greed
- 75-100: Extreme Greed, potential selling opportunity
Market Breadth
Measures: Participation in market moves
Indicators:
- Advance/Decline Line
- New Highs vs New Lows
- Percentage above 200 MA
Trading use: Divergence between price and breadth signals potential reversal
Applying Sentiment to Trades
As a Contrarian Signal
At sentiment extremes:
- Consider the opposite position
- Tighten stops on existing positions
- Be cautious about following the crowd
Example: VIX spikes above 35, the crowd is fearful. Start looking for buying setups.
As Confirmation
Sentiment aligning with trend:
- Trend more likely to continue
- You can size up
- Reversal is not imminent
Example: Uptrend with rising but not extreme bullishness. Trend is healthy.
As a Timing Tool
Sentiment extremes help timing:
- Wait for an extreme reading before a counter-trend trade
- Use sentiment to fine-tune entries
- Combine with technical analysis
Sentiment in Your Weekly Routine
Weekly Check
Add to your process:
- Check VIX level
- Review Fear and Greed Index
- Note extreme readings
- Adjust directional bias
Position Adjustment
Based on sentiment:
- Extreme bullishness: Reduce long exposure
- Extreme bearishness: Look for buying setups
- Neutral: Trade your normal plan
Risk Management
Extreme sentiment = elevated risk:
- Reduce position sizes at extremes
- Tighter stops
- Prepare for reversals
Mistakes to Avoid
Being Too Early
Sentiment can stay extreme for weeks. Do not fight the trend because a single indicator is elevated.
Ignoring Price Action
Sentiment is secondary to price. Confirm with technical analysis before acting.
Over-Reliance
Sentiment is one input among many. Do not base trades on sentiment alone.
Put Sentiment Data to Work
Extreme readings flag opportunity, but you need to track whether your contrarian trades produce results. Sentiment without performance data is guessing.
SwingFolio correlates your trade results with sentiment conditions so you can see the pattern. Check it out.