Collective feelings have implications

Mass psychological extremes are normally predictors of important trend changes.

OVERVIEW

Measures of market sentiment generally correlate with the market though they tend to offer additional insight from a contrarian perspective at turning points – which is where they tend to become the most extreme. The general rule we apply is that the greater the sentiment extreme and the longer it tends to persist, the higher the degree of the developing reversal.

One very important aspect of sentiment analysis is that sentiment does not have timing. In other words a market will not just reverse a powerful up or downtrend just because the psychology is extreme. Other conditions conducive to the reversal must be in place for the reversal to actually materialize, such as deteriorating breadth, diverging momentum, falling open interest, a lower level of activity and of course some sort of price crack down. When other stars are properly aligned, the extreme sentiment readings become more significant and that is when we will pay more attention to them.

Popular sentiment surveys, surveys of newsletter writers, professional money managers or retail traders, the breakdown of speculative and commercial positions as shown by the commitment of traders data, implied volatility curves and surfaces, the gaps between historical and implied volatility and even the overall tenor of news and events are measures of market sentiment we are keenly aware of at all times.

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