The Psychology Of Sentiment Indicators

Includes: FXB, FXE, FXF, FXY
by: Philipe Saroyan


Understanding the role of sentiment in the grander scheme of things.

The role psychology plays with sentiment indicators.

Suggested readings included.

A lot can be said about sentiment in the markets, but it's very interesting how social media can become a metric for professional traders and investors. Although, notoriously a unreliable indicator, investor sentiment is by far only a component to the whole factor for sentiment. Where investor sentiment is concerned with the rationale for investment choices and willingness to expend, sentiment indicators have more to do with the psyche of markets sentiment can be defined in different ways. Being able to validate what is a level of sentiment with analytical data is highly useful. This article covers differing sentiment; how sentiment may belong to an asset-pricing model; and finish off with the significance of NLP programs in news sentiment, how investors may succeed merely from mental perception.

Differing sentiment

First things first: How exactly do we get value from sentiment indicators and such data analytics? The answer is simply by knowing how they differ, and what are the expectations for retaining earnings from each indicator.

The comp. chart below illustrates the difference in the CEFD indicator for major currency ETFs, (NYSEARCA:FXB), (NYSEARCA:FXF), FXY), versus Euro ETF (NYSEARCA:FXE). the differing sentiment indicators, and what each equity line represents. The compiled data is from the latest available date from each of the ETF CurrencyShares(NYSE:R), from Yahoo Finance! and the fund company website.

Chart 1 Comp plot for CurrencyShares

Sentiment Equity Lines Graph

Chart SEQ Chart \* ARABIC 2 Sentiment Equity Lines Graph

In the above graph, data was compiled from 3/2014-5/2016 from Social Market Analytics and the proprietary Options Sentiment Indicator (OSI), calculated as the total daily open interest for options sentiment, depicted by the red and blue lines, respectively. The purple line is the composite of both, and the gold line is the underlying price change for the Euro ETF .

The red line represents our proxy for sentiment, and is made up of the 5-day Raw Score, which is an unfiltered sentiment score from SMA based on all the text analysis from what people were saying about during this timeframe. This equity line is closest to the Social Media Factor (NYSE:SMF), which is simply the composite sentiment from social media data. The blue line represents the options sentiment, a top-line market sentiment that adds all the daily open interest for options. The purple line is a composite of both the SMF and the options sentiment. When testing the data, research shows that as you might expect, the Social Media Factor is able to explain most of the price movement of FXE, compared to the options sentiment indicator. The point of this comp. chart is to understand that, since the redline is our main factor for sentiment, we shouldn't disregard the options sentiment indicator, but rather know when is an opportune time to go from the blue line to the red line.

As it pertains to your daily activity as an investor, you will notice that when the equity from the options sentiment becomes greater than the equity line from the SMF, the red line, it's time to lock in your profits from the OSI and go to the red line.

That's because the red line is able to retain earnings in the long-run as a proxy for sentiment, whereas the options sentiment can only be defined as a temporal earnings pot for speculation.

Asset-Pricing Models

Here's the formula for the standard error of the asset-pricing model, including the social media factor:

In the grander scheme of things, the blue line can be profitable to the investor when knowing how much of a 'noise' factor is part of the entire variable for sentiment, in this case SMF. If the blue line is proportionally too high to the red line, that means your retained earnings for trading sentiment is bound to disappear. It's very important to understand, that although sentiment can be a wonderful application of market psychology and an imminent tip-off for forward-looking expectations, it simply is not an input in an aggregate pricing model. The equation for aggregate demand of the economy is as follows:

The Wealth Effect

This means that Gross Domestic Product (GDP) is equal to the total of consumer spending, government expenditures, investment expenditures, plus net exports. Because the stock market is a leading indicator for the economy, and only a proxy, sentiment does not affect the fundamental value of the economy. Only so much as investments dispensed to consumer spending, via a sustained 'wealth effect', does sentiment play a role in an asset-pricing model.

This propensity to spend based on investment outcomes has more to do with investor confidence measures. When the difference between investor confidence, market sentiment, and consumer confidence, is clear, it's easier to see how sentiment can be included in an asset pricing model. However, the real work is in understanding the difference between investor confidence and consumer confidence as it applies to the aggregate.

The propensity to invest is the focal point for investor sentiment research. Market sentiment indicators cannot imply any future expenditures in investments or consumer spending. They only suggest this, but it is non-material. In other words, no matter how likely investors may seem to want to invest or spend based on the indicator, it simply does not affect the input for aggregate demand.

This is why prevailing research shows that the sentiment factor is only valid in the long-run, not in the short-run. See research from Allis & McCallig (2007).


Similar to brain wave activity, sentiment is meant to be an accurate picture of people's ebbs and flows towards a single stock, ETF or index. In this way market participants belong to a social construct that can be analogous to bees in a hive. This framework for understanding markets is chaotic, and not everything, but applicable to the study of so-called NLP-neural linguistic programming-the practice of making rational decisions from perception alone.

Because almost all technical indicators are merely a representation of what is already public information, a sentiment indicator can only be a speculation of what is unknown. Without the processing of millions of pieces of information, we can still gain the same knowledge from a sample set of similar information. Our mental perception would result in a finding similar to the sentiment indicator, except with greater strength in conceptualizing the information, minus the inability to anchor a proper value for each days' worth of gleaning. Context is the framework that says time is money, or that one financial investment is better than another, all else remaining equal. Sentdex online does a very good job at explaining how to build a sentiment indicator from NLP.

In the interest of financial and investment analysis, context is one of the greatest motivating factors for analysts and decision-makers. This can be the very reason to invest, or to be alarmed, of a threat to our investments, etc…

This context is easily captured in our analytical minds, but not easily captured by NLP programs, or sentiment indicators.

Being that NLP is recursive in nature, NLP programs are in fact a revision of the original framework, which has more to do with innate psychology. The ability to process and make rational decisions based on information is the technique of one who is successful. The success of a liquidity provider, an inherently imbalanced risk trader, hinges on his or her ability to ascertain the nature of his or her risk.

Just like a skydiver knows his plummet, and must become well prepared for the conditions of his flight, so to should sentiment traders know where they are with their risk factors. Because markets cannot function as merely a perfect micro economic structure governed by inherent value for prices all the time, means there must be times where markets are not perfectly efficiency. In other words, markets are not always bound by the theory of Efficient Market Hypothesis. That's why it's so important that the sentiment chart is a true reading of the NLP program. To better understand this sentiment activity, is to better understand the framework for technical analysis, and begin making higher grossing decisions.

Suggested readings:

Allis, P., and McCallig, J. (2007) Do Stock Market Returns Affect Consumer Sentiment? An Irish Study. Irish Accounting Review, Vol. 14, No. 1, 1-13

Schwager, J. The New Market Wizards. Harper Collins, 1992.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.