The dollar gained traction in the wake of central bank activity. Both the ECB and the Federal Reserve changed their interest rate policy in the second week of June, which has encouraged positive dollar sentiment. If sentiment becomes too robust or too negative, markets will reverse making it important to understand how to measure sentiment. One way to measure market sentiment is to use market psychology via the iFOREX market sentiment tool. By analyzing sentiment in conjunction with other analysis, you will be able to determine future market movements.
What is Sentiment
Sentiment, which is also referred to as confidence, describes market psychology. Sentiment determines how bullish or bearish investors are toward a security or currency pair. When sentiment is high, confidence is brimming and when sentiment is low, investors can be despondent. Sentiment is often used as a contrarian indicator. When sentiment become too low, many investors will look for a rebound, and when sentiment is too high, some will look for a selloff.
What is Market Psychology?
Markets move in a cyclical fashion. As they move, so too does market psychology. Market psychology is the market’s overall mood toward a tradable instrument. It’s important for you to understand if a market is over exuberant or depressed. Buying a security when the markets are exuberant means that you might purchase at the highs. Selling when markets are depressed means that you might wind up selling at the lows. It’s important that you use some form of indicator that helps you determine market psychology.
There are several types of indicators available to help you determine market psychology. You can use price action, volatility or volume. While market sentiment is not an exact science, it is a very helpful building block in helping you make your trading decisions.
One of the most commonly used sentiment indicators is a volatility index. Volatility describes how much a security or currency moved, or how far it will move in the future. Future movements of volatility are captured in option prices. The most widely used volatility index is the VIX. This index captures the estimates of option traders with regards to how far the S&P 500 index will move over the course of the next 12-months. There are VIX indices on commodities as well as currency pairs.
The VIX measures the implied volatility of the “at the money” strike prices on the S&P 500 index. When the VIX hits extreme levels, fear is prevalent. When the VIX slumps, complacency sets in.
The Relative Strength Index
The relative strength index (RSI) is a momentum oscillator that measures sentiment. The RSI measures the acceleration in prices and creates an index that can be used as a gauge for sentiment. When the RSI moves above an index level of 70, market conditions are considered frothy. When the RSI moves below the 30 level, market sentiment is often considered to be too low.
Investors often use breadth indicators which is a group of indicators that calculates the number of shares that are increasing and decreasing. They also measure the changes relative to the number of shares that are open. By using a combination of sentiment indicators, you can determine the true mood of a market.