Methods of measuring stock sentiment in day trading
Stock Sentiment is a growing analytical tool within the field of day trading, however various methods can be used to measure stock sentiment intraday. Note that here we discuss a select few of the most commonly used market sentiment indicators, therefore this is far from an exhaustive list.
VIX Index:
The VIX (Volatility Index) shows the expectation of the price of S&P 500 options in 30 days time (a brief definition of options is given in the ‘put to call ratio’ section below). It allows investors who are concerned about a potential fall in the S&P 500 to hedge their portfolio with options which will limit their losses in the event of a downturn, hence it shows investor sentiment about the general market and is known as the ‘fear index’.
It is also a leading indicator of the S&P 500 with an inverse correlation, meaning that when the VIX rises, this supposedly precedes a downward move in the S&P 500. The VIX is not an indicator of immediate market movement, but a leading indicator in the near term (due to the fact that it shows volatility expectations in 30 days time). Therefore, for intraday trading, it may be useful to look at the VIX’s movement to help gauge sentiment but it should not be taken as an indication of immediate S&P 500 price movement.
Put-Call Ratio:
The put-call ratio is the ratio of the volume traded of stock put options to call options. A put gives the investor the right but not obligation to sell a stock up to a predetermined date in the future and a call is the same but it gives the investor the choice of buying the stock in question. The ratio shows each put traded per call for that stock and therefore a ratio greater than one would imply bearish sentiment around the stock (because more traders want the choice of selling the stock than buying it). With the opposite being the case for a ratio of less than one (more traders want the future choice to buy than to sell).
One of the many uses for the put-call ratio would be in a contrarian strategy, buying on days the ratio is above 1 (bearish sentiment) and selling on days the ratio is below 1 (bullish sentiment) and looking to profit from a correction.
High-Low Index:
The high-low index compares the number of stocks that are making new 52 week highs with those that are making new 52 week lows within an index, with one of the most common being those within the S&P 500. It is a 10 day simple moving average which is calculated as the proportion of stocks making new highs to the total number of stocks making new highs and those making new lows out together.
The high-low index can be used as part of a bullish or bearish bias, for example only taking long positions if the index is above average (50) and short if it is below.
Bull/Bear Ratio:
The bull/bear ratio is a soft data indicator of sentiment. Every week, Investor Intelligence (a financial data provider) asks 100 top investment advisors their opinion on future market movement. They answer in one of three ways: bull, bear or neutral. The final number is the ratio of bullish responses to bearish responses (i.e. how many bulls responses there are per bear).
This simple ratio can be used to assess where current market expectations are to give traders an idea of what other market participants are currently thinking.
Limitations of Sentiment Indicators:
As a general principle, sentiment will follow price. Consequently, sentiment will almost always be at an optimistic extreme before an important top and at a pessimistic extreme before an important bottom. While important tops and bottoms in the market do imply a sentiment extreme, the reverse implication is far from always true. For example, the share price for a particular equity could be on a consistent uptrend for several weeks, the stock sentiment will still be overwhelmingly positive even if the trend was emerging as part of a long-term shift in price. As a result, extreme readings from sentiment indicators cannot be used as market timing signals. “The stock market can remain irrational longer than you can remain solvent” (Keynes) is a particularly relevant saying which should caution investors from entering a large contrarian position based solely on a sentiment extreme.
A prime example that demonstrates the limitations of sentiment indicators is the performance of the US Stock Market in the last decade. The graph (right) illustrates the price of the S&P 500 from 1987 onwards, with each red line signifying a period where the bulls outnumbered the bears 3 to 1. Aside from the dot-com collapse, which can be considered an outlier, each major downturn in price has been preceded by an overwhelming Bull/Bear ratio. Despite this, notice there have been many occasions where a red line has not coincided with a price reduction. Over the past 10 years, we have ridden a raging bull market, which has been embodied by the bull/bear ratio reaching ‘dangerously optimistic’ levels numerous times since 2013. Since the March 2020 lows, sentiment has been consistent with a bull market top, yet there is no indication from the price action that this bull run has finished.
This is why it is important to always look at context before marking a specific value as extremely optimistic or pessimistic – what constitutes an extreme sentiment will naturally vary over time. In this situation, the 3.0 Bull/Bear ratio is far less of a problem in a bull market compared to a bear market.
Here we have discussed a few of the most commonly viewed indicators in day trading which contribute to the effective analysis of trader sentiment, including the VIX, put to call ratio, high-low ratio and bull/bear index. Remember, each indicator has its limitations and is best used in combination with other analysis and/or indicators.
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