Of the factors that drive stock prices market sentiment can be both the most obvious and the most elusive to recognize. The long term price of a stock is determined by its fundamentals, namely how much money company makes and the degree to which it continues to make money over the years. But, over the short term, prices are determined by what investors and traders believe will happen next. When there is an unspoken consensus that a stock will be going up, down or sideways and prices react accordingly, that is how market sentiment drives prices.
How to Read Market Sentiment
Market sentiment is not what you think about a stock. It is what others think and the degree to which they are likely to act on such sentiment. A commonly used indicator of market sentiment is the VIX index. This indicator is based on the ratio of near-term puts and calls. Referred to as the fear index the VIX indicates market concern, indecision, and even panic. Another indicator is when investors start buying safe haven assets like US Treasuries or Forex traders start bidding up the US dollar. The High / Low Index and stock price breadth similarly indicate either tranquil or worried markets. CNN has a Fear and Greed index that is useful. And, simply looking to see what stocks are being searched for on Google will tell you which stocks are likely to show volatility in the coming week.
Market Sentiment versus Technical Indicators
Successful option traders are always aware of the fundamentals of the stocks and indexes that they trade. However, they use technical analysis to trade in the short term. And, while fundamentals are great for predicting long term trends, market sentiment indicates where prices are going today, tomorrow, and next week. Thus, success option traders tend to use a combination of market sentiment assessment and technical analysis to understand the market and choose their trades. A trader who uses a combination of short and long-term moving averages is able to smooth out the static in the market and more-clearly see trends. When one or more of the market sentiment indicators leads one to believe that the market is going to go up or down, it is always wise to consult technical indicators for confirmation of where you believe emerging market sentiment will take a given stock or index.
Trading Market Sentiment
There are times when the sentiment of the market is not reflected in your view of the fundamentals or the technical indicators that you are following. If such emerging sentiment can be traded by purchasing a deep out of the money call or put it is often worth the time and investment to place such a trade. An alternative is to use a strategy like a bear call spread in which you can lock in opportunity at a low and absolutely predictable price. As a rule, one should never risk a lot of capital and especially never place a trade with bottomless risk simply based on market sentiment that is not supported by the intrinsic value or short term technical factors for the stock in question.
Time Frame of Market Sentiment
Market sentiment indicators like the VIX both reflect where the market may be going and drive the market as so many traders and investors use the VIX as a guide. Thus, the time frame during which you can rely on the VIX or other indicators may be quite short. If your reading of market sentiment is confirmed by fundamental and technical indicators, trading it can be profitable. If you are simply confused by what the market seems to be thinking, you will never lose money by simply sitting this one out.