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How to Use Sentiment Analysis versus Technical Analysis

When the markets begin to chop around violently there are several tools that you can use to help you trade successfully. When the market starts to experience choppy online trading conditions where volatility is elevated you need to have several tools to make sure you know what is likely to happen in the future. Sentiment analysis in conjunction with technical analysis can provide you with the information you need to successfully navigate volatile markets.

What is Technical Analysis

One of the most common types of analysis is technical analysis. This is the study of past price movements to help you determine the future direction of the assets you are trading. Technical analysis can include using prices to form levels of support and resistance, where supply and demand are located. It can also help you determine if a trend is in place or if the markets are poised to trade sideways. Technical analysis can also define momentum when price action is accelerating or decelerating. Additionally, technical analysis can tell you if the price has accelerated to the extent that it is overextended. This could be “overbought” or “oversold”

What is Sentiment Analysis

While you might have a good handle on how prices are reacting based on technical analysis, it’s hard to only use these metrics to evaluate the market’s perception of where prices will move in the future. One of the best ways to determine confidence or the lack of confidence in the price of a security is to use sentiment analysis. This describes how market participants feel about future price movements. There are several sentiment analysis indicators including the use of options to define sentiment.

What is an Option?

An option is the right, but not the obligation to purchase or sell a security on a specific date at a certain price. You do not have to trade options to use options as a sentiment indicator especially if you want to determine if a market is likely to be volatile in the future. There are many variables that are used to price options. The most important input is implied volatility. Implied volatility can be used as a sentiment indicator to determine the future volatility that is priced into a market.

Using Implied Volatility as a Sentiment Index

One of the most common indices to use to determine sentiment is the VIX volatility index. The VIX measures the implied volatility of the “at the money” strike prices on the S&P 500 index. The VIX is only one of several implied volatility indicators that can be used to find implied volatility. The Chicago Board of Options Exchange produces several indices that measure implied volatility. For example, there is a Euro VIX, a gold VIX, and oil VIX a silver VIX. There are even VIX indices on popular stocks like Apple.

Using Implied Volatility as a Sentiment Index

A chart of a VIX can help you with the sentiment as it relates to volatility. When the VIX is elevated like it was in March of 2020, the market is pricing in future volatility. As the VIX declines sentiment is improving as market participants begin to price in less volatile market conditions. You might even consider using technical analysis in conjunction with your sentiment analysis to determine if the price of an asset will be more volatile or less volatile in the future.

The Bottom Line

Using sentiment analysis in conjunction with technical analysis can help you get a better handle on the future state of a market. Sentiment analysis provides you with a gauge of future market conditions. When this is combined with technical analysis, you can forecast the combination of future price movements with future market volatility.

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