Market sentiment indicators measure the feelings of the market participants regarding how positive or negative they regard the market. Primarily, they’re used to provide information of the mass psychology of average traders (not professional traders) as to how bullish or bearish they are about the market in general. Traders and investors alike use this information as another type of broad market indicator in the ways describes here.
Mood swings don’t always result in market swings
Market sentiment indicators are generally contrarian indicators, meaning that when most people are bearish, it may be a good time to buy, and when most people are bullish, it may be a good time to sell. Such sentiment indicators are most useful when they’re at extremes and not fairly neutral (which they are most of the time).
Swings in sentiment from mildly bullish to mildly bearish haven’t proven to be of much significance. Instead, the dramatic emotional swings of people’s feeling about the market most often create the highs and lows most pronounced on the charts.
Such recent experiences as the real estate bubble and, before that, the tech bubble both popped at the top of the most enthusiasm on behalf of the masses.
Sentiment indicators as contrarian indicators
One of the most commonly used sentiment indicators is the put/call ratio, which is simply the ratio of the number of put options to call options. A bullish sentiment occurs when the number of call options traded is greater than the number of put options traded. However, only the extreme sentiments provide meaningful signals.
Because sentiment indicators are contrarian indicators, it makes sense to use such indicators that measure the feelings of amateur — that is, losing — traders. The put/call ratio may seem ideal for this because retail options buyers are notorious for losing money.
However, keep in mind that options were originally created to manage risk by hedging positions. Therefore, professional traders participate in the buying of options as well and diminish the contrarian effect of using the put/call ratio as a sentiment indicator.
To address this issue, you may want to consult the equity-only put/call ratio, which doesn’t include the index put buying statistics of the professional traders who are hedging their positions.
You can find the equity put/call ratio on CBOE.com in the CBOE Daily Market Statistics section in the left sidebar.
You can also consult many other sentiment indicators. Here are some good ones you may want to consider:
Investors Intelligence published by Chartcraft
American Association of Individual Investors Sentiment Survey
Barron’s Investor Sentiment Readings
Money.CNN Fear and Greed Index