In this article, you will read about ways to interpret market sentiment such as:
- recognizing fear and greed in asset movements,
- following market sentiment indicators,
- how trading news affects sentiment,
- and the importance of risk management.
Dramatic market movements became the new normal before, during and after the COVID-19 pandemic. Indeed, it would be difficult to pinpoint a period since 2008 when the financial markets were calm and steady, and we could even argue that expecting them to be calm and steady is unrealistic for one simple reason.
Demand and supply are driven by sentiment and sentiment is not always rational.
In the context of trading and investing, market sentiment is defined as a psychological attitude towards a security or financial sector. The tendency of market participants to be irrational is not a new theory, it was first revealed by economist John Maynard Keynes in his book The General Theory of Employment, Interest and Money written in 1936.
“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits – of a spontaneous urge to action rather than inaction…” John Maynard Keynes.
The term animal spirits has become a catchphrase describing a type of crowd psychology in which a sudden urge to sell or buy sweeps across the markets resulting in strong upward or downward trends, also known as volatility. This is a double-edged sword that creates opportunities and risks at the same time.
Recognizing fear and greed in market movements
Fear can arise when there are negative news headlines, either on the financial, the economic or the geopolitical fronts. When the market psychology is fearful, it can result in mass selloffs and rapid price declines in financial instruments like currencies, stocks and indices. The opposite reaction to fear is greed driving market prices upwards. In these trends we might see price bubbles forming around asset prices that somewhere down the line will likely burst after becoming unsustainable or obviously irrational.
In between fear and greed are the milder sentiments of optimism and pessimism, skepticism and even indifference. But how can we tell which mood is prevailing? Closely observing market trends and news headlines is one way and the other is to follow market sentiment indicators.
Following market sentiment indicators
Sentiment indicators like the VIX are statistical market models that track the prevailing mood. An acronym of Volatility Index, the VIX spikes when volatility rises in the US stock markets. It is based on prices in the S&P500 and can be a helpful indicator to confirm volatility.
Other sentiment indicators are the High-Low Index, the Bullish Percentage Index and Moving Averages in Technical Analysis, all of which can point towards market psychology.
As a beginner, you can now understand that there are a range of psychological attitudes towards the markets and start factoring in the need for risk management. Trading and investing platforms like MT5 enable you to add stop loss orders to your open positions. You can read more about risk management in our article Top 10 Forex Risk Management Tips.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
