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Sentiment Indicators

Sentiment indicators help define investor expectations of the market. Market indicators that help gauge investor sentiment include the put/call ratio, the VIX, odd lot sales, and ratio of bullish versus bearish investment advisors. These indicators help define what investors are doing.

Contrarian investors will use this information to go in the opposite direction of the crowd, which has proven to be a successful strategy at market tops and market bottoms. The majority of investors are very bullish at market tops and very bearish at market bottoms.

If the vast majority of investors are extremely optimistic, then the pool of potential buyers is probably limited because most investors are already in the market. The large pool of optimists are potential sellers who can create a rush to exit the market at signs of trouble. Similarly, if there is a high level of anxiety in the market, then many investors will be in cash due to fear of the market. The large pool of pessimists are potential buyers who can create a rush into the market at the early signs of recovery.

The VIX goes up when there is a lot of fear in the market because option traders are willing to pay a higher premium when they purchase options. Higher option premiums result in higher implied volatilities (driving the VIX higher). A high value of the VIX is a bullish indicator that a market turnaround may be imminent. When the VIX is at a low value in the teens, it indicates complacency in the market - there is not much fear. This tends to be a bearish indication for the market.

When the put/call ratio is high, the majority of investors are predicting a downturn in the market, which is bullish. When the put/call ratio is very low, investors are optimistic, which is a bearish indication that a market turnaround may be imminent.




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