There is no denying that paying attention to sentiment-driven indicators could tilt and investor/trader to the right side of a trend. Of course, no methodology is perfect but the probabilities, patterns and past experiences side with the evidence. Emotional responses to news, events and price movements dominate market action, and we can use tools to quantify and graphically display when the emotions are at extremes – and a time to take the other side of the trade.
Currently the preponderance of evidence is tilted to the bullish side, and that is usually a red flag. Why is that? Simply put, when too many lean to hard in one direction then like a wave, the markets move the opposite. This is just a natural reaction and for those who do not want to be part of the crowd, the contrarian trade is the best payoff.
However, we know markets do not move exactly as believe they should. Conditions can/do persist longer than we expect. For instance, some current polls have been flashing a wide divergence between bulls/bears for several weeks. That condition is ripe for a contrarian trade, but actually that has not been a winner for an extended period. The VIX, which we talk about frequently – has been very low for weeks, entering a downtrend following ‘Brexit’ and refusing to rise. This is a sign of complacency and also begs for a contrarian trade. Again, this saw little reward over the past two months.
So, you may wonder – why bother if the sentiment is triggering a trade setup but is not working? The key is to look for trend reversals, and those will be apparent. The market conditions us to react a certain way when markets ebb and flow – now we have a ‘buy the dip’ mentality. That will change, but nobody will tell us. However, sentiment indicators may be the first ones to give a clue.
