Market sentiment analysis is an evolving technique which can be effectively used to compliment fundamental, quantitative and technical analysis. Sentiment analysis is also one of the more successful methods of including the effects of market psychology in a trading strategy. Empirical evidence suggests that investor sentiment is one of the most reliable indicators of future price movements.
Market sentiment is a qualitative measure of the attitude and mood of investors to financial markets in general, and specific sectors or assets in particular. Positive and negative sentiment drive price action, and also create trading and investment opportunities for active traders and long-term investors.
It could be described as the aggregated public opinions, views, feelings, mood, or outlook that make up the market psychology at any point in time. Because market sentiment cannot be exactly defined or measured, there is no specific correct or incorrect way to conduct sentiment analysis. Nevertheless, there are ways to use and combine other indicators that reflect market sentiment.
How emotions affect the stock market
In the short-term markets are driven by emotion – fear and greed in particular. Traders and investors are often driven by one form of psychological need or another. The fear of missing out, FOMO, can cause investors to pay prices for an asset that have no basis in reality. In that case they are not buying because the asset is a good investment, but because they need to do something to avoid the feeling of missing out. During bear markets, investors will often sell stocks at prices well below their value because they need to stop feeling the pain of losing money.
These are both examples of how emotions can force investors to make decisions that aren’t rational. It also shows why major market highs and lows are usually accompanied by extreme levels of positivity and negativity. Sentiment is highest just before major market tops, and lowest just before major market bottoms. By using sentiment analysis, investors can attempt to determine when the market is being driven by emotion rather than by rational decision making. They can pick up changes in sentiment before there is any news to explain the behaviour of stock prices.