The investing crowd is often wrong when it comes to key trend turning points i.e.whether an up or downtrend of the market is about to change. If this is the case, one would want to measure the crowd's expectation at potential turning points to identify extreme bullish or bearish markets.
Sentimental analysis does just that. It measures the emotions of the investing crowd in an attempt to identify extreme bullish or bearish indications. Once an extreme level has been identified, a trader can use this information from a contrarian viewpoint either to confirm other trading indicators or as a stand alone indicator.
If an extreme bearish sentiment exists, a contrarian would interpret this as a bullish indicator. If an extreme bullish sentiment exists, a contrarian would interpret this as a bearish indicator. While an extreme sentimental reading can be used as a stand alone indicator to identify possible counter-trend moves, it should only be used as a supplemental indicator for confirmation.
The following example will demonstrate how sentimental indicators can help confirm other trading indicators. Suppose a stock has had a nice run up and is now approaching a significant resistance level, the stock is upgraded by one of the major brokerage firms, and gaps up near the resistance level on heavier than usual volume. Because the stock has been upgraded, the crowd is now going to feel very optimistic and bullish about the stock, which is why it gapped up on heavier volume.
This happens all the time. Each time a brokerage company upgrades a stock for whatever reason, you can see the stock going up even if it's just for this one day.
The reality is that this final gasp of buying has now most likely committed the last remaining sideline money to the stock and there is nothing left to propel the stock even higher. The over-optimistic public at a major resistance level is an excellent contrarian indicator to confirm the original trading signal.
In addition to extreme sentiment which can be easy to spot, one also needs to know that complacency in the market and media also give a contrarian signal that investors? expectations are still too high despite the low price, and that a weak stock, sector or market has still not found a bottom. At a true bottom, investor fear should have reached an extreme level as the crowd finally becomes convinced there's still more desaster ahead.
