Measuring Stock Market Sentiment With Extreme Indicators
Technical indicators, especially those specifying a particular performance level between two extreme values, help investors identify and measure market trends.
A recurring theme in the analysis of stock price performance is the concept of exhaustion, which applies to advances as well as declines. A period of exhaustion exists when the price of an asset moves in one direction as far as the market will allow. At that point, the number of interested buyers diminishes, and the sellers direct the price movement, or vice versa. Exhaustion indicates a trend reversal. Exhaustion gaps appear on stock price charts, indicating a stock’s final attempt to reach a new high with an abrupt move on high trading volume. They signal price reversals because traders frequently assume that the abrupt advance resulted from excessive enthusiasm.
A widely used market sentiment indicator is the put-call ratio of trading volume for put options, compared to the volume for call options. The put-call ratio is calculated by dividing the put volume by the call volume. When the ratio is extreme in one direction, it implies that the market is signaling an extreme sentiment.
Moving averages help identify the price of a stock over a specified period. Because price action can become erratic, moving averages clarify the asset’s market value during that timeframe. Moving averages can identify support and resistance levels because other market participants view them as such. One way to measure extreme sentiment from moving averages is by seeing how far the price is from moving averages. Traders measure this by looking at the standard deviation.
The moving average convergence divergence (MACD) is the difference between the 26-day EMA and the 12-day EMA. The 26-day EMA is subtracted from the 12-day EMA. When a stock price advances, the 12-day EMA is above the 26-day EMA. The nine-day EMA of the MACD is the signal line. A buy signal occurs when the MACD crosses above the signal line, and a sell signal occurs when the MACD crosses below it. When the MACD is a significant distance above the signal line, many investors interpret that as an extra time cushion before the arrival of a sell signal. However, when the 12-day EMA makes a dramatic rise above the 26-day EMA, it is a signal that the stock is overbought and may soon experience a price drop. This situation is another example of how the exhaustion principle can indicate a trend reversal.
Divergence can provide another trend reversal signal. When the stock’s price moves in the opposite direction of the MACD or any other technical indicator, it can signal a reversal of the current trend. Positive divergence describes situations in which a stock’s price reaches a new low as the indicator begins to climb. Negative divergence occurs when the stock’s price hits a new high as the indicator begins to decline. However, MACD divergence can provide false signals. Although MACD divergence indicates declining momentum relative to prior price swings, lost momentum does not necessarily indicate a price reversal.
The relative strength index (RSI) is a momentum indicator that compares the number of recent days when a stock closed at a higher price than the previous session, compared to the number of recent days when the stock price declined. An RSI above 70 indicates that the stock is overbought, and an RSI below 30 indicates an oversold stock. For example, during the period from April 27, 2016 through May 13, 2016, Apple Inc. (NASDAQ: AAPL) was oversold because its RSI was below 30 throughout that entire period.