Have a feeling that’s validated by the reality of a situation? You could be primed for sentiment trading. Sentiment traders look at markets through a behavioral lens, to identify the general feeling surrounding markets and securities. Then, they base their positions around how they believe the market will respond. 

Sentiment traders tend to be day traders, swing traders and general technical traders. They view securities and markets within the context of a pattern. Then, they seek to understand how bullish or bearish sentiment affect these patterns. Is a bearish pattern trending into a price reversal? Is investor sentiment high on a stock that’s following a continuation pattern? Recognizing how sentiment affects behavior and price movements is key. 

Sentiment trading is more than just a feeling

Market Momentum And Sentiment Trading

Sentiment trading comes down to bullish and bearish outlooks. It contextualizes these outlooks within patterns, which can manifest as continuation or reversal patterns depending on the trend. The direction of a market’s momentum will influence how a sentiment trader looks at a potential position. 

For example, the inability of a security to break a resistance level might be a sentiment flag. A growing short position is another flag. The formation of a triangle pattern might be another. Together, a sentiment trader will realize these as a bearish outlook. They can expect the price of the stock to fall in the near future and can plan accordingly based on the culmination of the pattern they’ve identified. It’s the same for bullish sentiments. 

The goal of a sentiment trader is to step back and rationalize the behavior of the market. Sentiment traders give context to the up or down momentum of a security’s price. In doing so, they qualify patterns and enable themselves to trade with or against them. 

Trade With The Crowd or Against it

When you understand bearish or bullish market sentiment, you can choose to trade with or against it. If you believe a bullish market is only going to go higher, take out a long position. If you disagree with market sentiment, take out a short position. The power to form a valid trading thesis is based on an understanding of sentiment. 

Sentiment traders need to be both empathetic and analytic; feeling, but data-driven. If the price of a security is rising but there’s underlying bearish sentiment, you might choose to be defensive despite your impulse to chase the momentum. Likewise, technical analysis of a pattern might align with the current momentum. This gives you a sign to go long.  

Strict technical traders might trade only against the pattern they can see. Sentiment traders bring context into the fold. This can be especially useful in identifying faux patterns or seeing a pattern amidst convolution and volatility. 

Get Familiar With Sentiment Indicators

Sentiment trading is more than a gut feeling. In fact, it’s arguably the opposite. Successful sentiment trading comes from deciphering other investors’ gut feelings. To do that, analysts will look at several broad sentiment indicators:

  • The fear index: For broad pattern contextualization, sentiment traders check the moving average of securities against the VIX ETF. This fund reflects investor sentiment in option prices. It’s commonly called the fear index because it measures hedging. 
  • The BPI: The Bullish Percent Index (BPI) shows how bullish the market is. In practice, it’s a tool for estimating how over-bought securities are. 
  • Moving averages: 50- and 200-day moving averages give credence to patterns and can show investor sentiment. More important, when they cross, it tends to indicate major momentum changes. 
  • 52-week average: Where a security trades relative to its 52-week price scale is telling. If it trends higher than the average of major indices, it represents bullish sentiment. Lower than the aggregate index means bearish sentiment. 

The key to determining sentiment is context. Most sentiment traders compare a security’s sentiment to its historical behavior, as well as to major indices or sector averages. Identifying bullish or bearish sentiment at the security level makes pattern trading more reliable. 

The Drawbacks of Sentiment Trading

The biggest drawback of sentiment trading is simply the idea that sentiment can be irrational. Just because investors feel a certain way doesn’t mean that’s the reality of the situation. While sentiment is a strong catalyst for price, it’s not the only driver. Traders can’t get wrapped up in sentiment and discount fundamentals or technical analysis. 

Sentiment can also create problems in a vacuum. When the market or a sector shows bearish signs and a security remains bullish, it can rally investors. The longer this rally continues, the more its value becomes irrational. Sentiment traders need to be aware of these speculative traps. Grasping at winners in a bearish market can lead to unsavory positions that herald huge losses when sentiment finds ground again. 

Finally, remember that sentiment can change—rapidly. A company announces great earnings today and the price spikes. Tomorrow, they report an investigation by the SEC and the price plummets. While an extreme example, it’s one that illustrates the power of volatility. Beware noise traders or momentum traders who may be the core drivers behind irrational movements. 

The Bottom Line on Sentiment Trading

There’s one famous phrase that many sentiment traders live by: “Be fearful when others are greedy and greedy when others are fearful.” Of course, this mantra only works when backed by sound technical analysis and data-driven decision-making. What separates sentiment traders from less-informed traders is their ability to contextualize sentiment. Instead of being at the mercy of sentiment, smart traders learn how to capitalize on it. 

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