Sentiment indicators attempt to gauge the over all mood of the market. Generally speaking when a sentiment indicator shows an abundance of optimism, investors are wise to approach that market with a higher degree of caution. At first glance this may sound counterintuitive but if the vast majority of investors are very optimistic then it follows that the vast majority of investors are probably fully invested. Where will the added investment money required to drive up prices come from, if the all the money is already in the market? In fact, optimists are potential sellers and pessimists are potential buyers and therefore sentiment indicators can point to major turning points in the market. Traders who rely on sentiment indicators feel that the higher the level of anxiety in the market, the closer the market is to actually bottoming.
The put/call ratio is a common sentiment indicator. A put option gives the purchaser the right, but not the obligation, to sell a security for a certain price by a specific time. A call option gives the buyer the right, but not the obligation, to buy a security for a certain price by a specific time. An extremely high put/call ratio indicates fear in the market since significantly more investors are betting on a downturn rather than an upturn. An extremely low put/call ratio indicates an abundance of optimism as investors are aggressively betting on future stock market gains.
The Volatility Index (VIX) is another sentiment indicator: a high VIX reading indicates high volatility and tends to occur when fear is prevalent in the market whereas a low VIX reading indicates complacency which is typically associated with stock market tops.
A great source of sentiment indicators is at Chart of the Day.
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