Stock market is influenced by various factors that encourage or discourage the investors and traders to take a trading position in various market segments. Apart from fundamental factors and technical aspects, market sentiment is another important factor that can affect the stock price or other underlying security trading in the market.
Market sentiment is also known as investor’s sentiment is not related to the fundamental changes in the market. In technical analysis, the market sentiment is used to measure the current emotion of the investors towards the short-term movement of the market.
When fundamentals have not changed and the market is moved by the sentiments of the traders and investors, then it is called crowd psychology. It affects the entire market including the main index including the broader market, individual stocks and option pricing in the derivatives market. Today, we are going to discuss about how market sentiment affects the stock market, individual share prices and the price of options with indicators to analyse.
Topics Covered :
- What is Market Sentiment?
- Market Sentiment Indicators
- How Does Market Sentiment Affect Option Price?
- Conclusion
What is Market Sentiment?
In the stock market, market sentiment is known as the emotional mood of the investors and traders that show their attitude or expectations towards the market movement. The sentiment of market can be positive, negative or natural depending on the market conditions.
The sentiment of the market can show the short-term perception of investors or traders towards the whole market, a particular sector or individual stocks. To influence the sentiment of the market, there could be any factor like economic activities data, political movements, government or regulatory actions, global events and company-specific news or corporate actions.
The market sentiment would be clearly visible through changes in the market movement, either rising or falling. When the market sentiment is bullish, the index or stock price will increase, and when the market sentiment is bearish, the price will fall.
If you manage to understand the market sentiment it will help you to take well-informed decisions and trade positions into various market segments. To understand the market sentiment you have to use various types of market sentiment indicators.
Market Sentiment Indicators
To measure the market you can take help of various technical indicators that will demonstrate to you the current market situation, its trend and volatility factors or trading activities in the option market. Though these are only indicators that will help you know the sentiment of the market, but for taking buying or selling decisions you have to use fundamental analysis and technical analysis that will also consider all the factors that can affect the stock price.
Volatility Index (VIX):
Among traders, it is also known as the index of fear, which also measures the implied volatility of the underlying security. A higher value of VIX indicates the market is volatile and there would be high and low swings of prices in coming trading sessions.
In options trading, VIX helps to know the market sentiment towards the volatility levels, which means a range of highs and lows, the market can move. When there is impulsive movement in any stock, then option price will be also affected with volatile movement.
The High-Low Index:
This is one of the best indicators to know the market sentiment. Check how many stocks are trading at their 52-week highs and how many are trading at 52-week lows. If this High-Low Sentiment Index is above 70, it means the sentiment of investors is bullish. If this sentiment index is below 30, it means the sentiment is bearish.
Bullish Percent Index:
This market sentiment index is based on the chart patterns of all the stocks in the index. If more than 70% of stocks show a bullish chart pattern, then the market sentiment is considered bullish. While, if less than 30% stock shows a bullish chart pattern, it means the market sentiment is bearish or gives the signal of oversold market.
Moving Averages:
Moving averages are one of the most widely used technical indicators in the stock market that can be also used for knowing the market sentiment. Typically, traders use a 50-day moving average and a 200-day moving average to analyse the market sentiment.
When 50-day moving average line crosses over the 200-day moving average line, it is considered the bearish sentiment, while when the 50-day moving average line cross the 200-day moving average line from below and trading above means bullish sentiment in the market.
Put-Call Ratio (PCR):
This is the ratio of the call against the put that will also help you to know the market sentiment. When put-call ratio is high, it indicates the bearish sentiment; while a low PCR means market sentiment is bullish that also affects the options price.
Recommended Read: Explore Market Volatility and Trading strategies
How Does Market Sentiment Affect Option Price?
The option price is directly related to the spot price of the underlying security. When the spot price is changed, the option price also changes because of various factors that are considered in the option price calculator like time value, time decay, volatility and demand or supply.
As per the market sentiment, the option price also gets influenced mainly by demand and supply of the underlying security. As we know there are positive, negative or neutral sentiments in the market, let’s find out how these market sentiments affect the option price.
Option Price in Positive Market Sentiment
When the sentiment of the market is positive, the market will be in bullish mode with most of the stocks moving in the upwards direction. And with a positive sentiment and bullish trend, the demand for the stocks and various underlying securities trading in the different segments would be also high, which will increase the volatility resulting in the option price to be also high.
When market sentiment is positive traders trade with bullish option strategies that usually contain buying the call options or selling the put options. In positive market sentiment, the volatility becomes high which also raises the price of the option premium. But you can use various other technical indicators to confirm the trend and trade with the right strategy.
Option Price in Negative Market Sentiment
When the market sentiment is negative, the market tends to trade in a bearish mode in which most of the shares trade in a downward direction. In negative market sentiment, the trend is bearish resulting there is selling pressure in most of the stocks and other underlying securities. When there is high selling pressure, the option price of the put becomes high and call prices low encourage the traders to buy put or sell the calls to generate profits.
In negative market sentiment, traders trade with bearish option strategies like bear call spread, bear put spread or bear butterfly spread etc. However, in the bearish market the volatility index could be also high resulting the option prices will be also high. Hence in negative market sentiment, you need to use the indicators to confirm the trend and also analyse the options price chart before entering into any buying or selling position in the option market.
Option Price in Neutral Market Sentiment
Apart from positive and negative market sentiment, there is another sentiment called neutral sentiment in which neither market is bullish nor bearish, instead trading sideways within a range. When there is neutral sentiment in the market, the trading volume is low resulting in most of the stocks not having significant movement or moving with slight changes.
In neutral market sentiment, the volatility also becomes at the lowest levels, and the price of the underlying securities trading into various market segments also becomes less volatile. And when volatility is low, the option price also becomes stable or you can say trades at a reasonable price. In such a neutral market sentiment, you can trade with sideways trading strategies.
Conclusion
The sentiment of the market is influenced by the crowd psychology. Traders are sometimes optimistic, sometimes pessimistic or sometimes remain unbiased with indecisive opinions. And the sentiment can keep changing with the various factors that come into the effect like market-related news, events, rumours or forecasting of future movements.
However, when the market is rising it indicates the market sentiment is in bullish mode, while falling means the market sentiment is bearish, and when there is no significant movement, means market sentiment is neutral. In bullish and bearish both types of market sentiment the price of the underlying securities keeps moving in the single direction.
As there is no fundamental changes in the stock price, the option price also keeps changing as per the market sentiment. In positive sentiment, the call options become expensive, while in negative sentiment, the put options become costly. Hence you need to understand the market sentiments using the various indicators like option volatility and pricing strategies.
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