Gauging Sentiment in the Capital Markets

Sentiment is a reflection of investor confidence and can be measures using a number of tools that reflect the emotional construct of investors at the present momentum in the capital markets.  Sentiment is an important tool for investors as it tells you whether there is too much enthusiasm or unusual fear.  By gauging the current state of market participants you can determine if the time is right to enter the market.

There are a number of tools that an investor can use to determine whether the current environment is dominated by fear or greed.  By evaluating the current level of implied volatility, an investor can gauge sentiment.  Implied volatility measures how much investors believe a market will move over a period of a year.  It is quoted in percentage terms on an annualized basis.

When it is low, complacency is prevalent and investors are content with the current market environment.  When implied volatility is high, fear is broad based, and investors believe they need protection from adverse market changes.  Implied volatility is the main input used to price options.  The higher the level of implied volatility the more expensive it is to purchase an option.

There are also a number of technical tools you can use to gauge sentiment.  The relative strength index is one of the best.  The RSI calculates an index between 1 and 100 based on the current price of an asset relative to where it has been over the past 14 days (this is the standard default but any period of time can be used.

The RSI can also be calculated using months, weeks or even intra-day data such as hours.  When the RSI shows a reading that is above 70 a security is considered overbought and therefore sentiment is high.  When the RSI reflects a reading that is below 30, the asset is considered oversold and therefore sentiment is weak.

Another technique is to find a long term moving average and evaluate the number of days where the price of a security or an exchange rate is above or below that moving average.  A moving average is calculated by finding the average for a specific number of days.

On the next period (day) you drop the first period in the calculation and add the next period to create the new average.  By calculating the number of days above the x-day moving average and dividing that number by the number of days below the x-day moving average, you can calculate a sentiment index that helps you determine how bullish or bearish market participants are on a specific security.

Many traders also look at the number of puts outstanding relative to the number of calls outstanding.  This type of sentiment indicator is contrarian. When puts outweigh calls and the ratio declines, sentiment is considered bearish and when calls outweigh puts and the ration moves higher sentiment is considered bullish.

Sentiment can assist in the process of determining if a market is complacent or fearful and can help investors determine if it is the right time to take on a position in a security.