What every trader and investor should know about Market Mood Index. How can it protect them from severe loss and show great opportunity?
First component of my 3+ trading methodology is to understand the market mood. (You may read about the other two component and full details of my trading methodology HERE). The blog on pre-market view, I write every day before market open helps me understand how the global market mood and expectations have been evolving.
Trading is all about the future movement of markets. Traders who try to predict markets based on past price movements go terribly wrong almost every time. That’s why we traders use stop losses to limit out losses in case market moves against the trade. But what are markets? After all they comprise of traders, investors and other operators who buy and sell based on their view of where market is headed. This makes the collective human behavior an essential component of market behaviors. Then why can't we study and try to understood the collective human behavior. Its not easy, because trying to read the mind of millions of traders siting in different parts of the country and world is just not possible.
Luckily there are few indicators that captures the collective mood or sentiments of the market participants. They are called leading indicators because they supposedly "lead" the price movements. Put-call ratio, volatility index and even the max pain measure used by expiry day traders are some of the indicators that give us hint about what is going on in the minds of the traders and investors. These indicators offer tell-tale signs of how the underlying mood of the market is changing. This has potential to affect the market movement in the near future. The insiders and large institution may be able to keep their trades confidential and play the retail investors and traders. But even they can not manipulate volumes, put call ratio, volatile index or advance decline ratio easily.
Unfortunately there are no one standard indicator to measure the overall mood of the market. Every institution have their own version of such indicator. CNBC calls it fear and greed index, others call it market mood index. Large institutions have resources and capabilities to scan through large amount of data hence it could be more accurate. But they make their indicators are available to only a select few. Others who construct such indicators from publicly and easily available data publish them in the form of relative measure such as the one shown below.
Since the data is not made available in comparable chart form like that of price charts, it is difficult to study the relationship between the indicator and the price movement.
Therefore, I decided to have my own market mood index. The index is derived from the following data:
1. Daily closing price of Nifty50 Index
2. Daily turnover of all Nifty50 stocks- Cash value of all Nifty 50 stocks
3. India VIX Index
4. Advance Decline ratio of all stocks traded in NSE
5. Volume of shares traded in Nifty500 Index- Total number of shares traded.
6. Measure of how global market expectations are evolving. It comprises of movement of
US Market and Japanese yen – How did they close, bearish, bullish or neutral
MSCI Asia ETF traded in US – What is the western investors interest in emerging Asian markets
Asian Markets in the morning- How is the day starting. Bearish, Bullish or neutral start
After Market News surprise- How did overnight economic, market and political news flow surprise markets
One problem with all the above data is that they are measured differently meaning they are measured in different units. For example, Nifty closing price is like ten thousand "points" while the turnover is in tens of thousands of "crores". To make all these different types of data comparable, Data managers use a method called standardization of data. Accordingly, I standardize all the above data using standard deviation and mean. Now it can be used in the formulae to arrive at the final mood index. This series of data is then charted along with closing price of Nifty to understand how two are co-related.
Chart of Mood index from 01 Jan 2020 is charted below:
Dark blue line is the Nifty index. Closing price of Nifty is plotted on the right-side axis. The grey bars are the mood index, the orange line is five-day simple moving average of mood index. These two are plotted on the left side axis.
If the chart is closely studied, we can find that the price more or less follows the mood index after a gap of few days/weeks. That is a great thing because as expected the mood index works as a leading indicator of prices and leads the price movement by few days.
To study this aspect of mood index leading price movement by few days, I have shifted nifty index backwards by 15 days. Only the index is shifted, while other two data, that is mood index and 5-day SMA of mood index remains as it was.
Now the relationship becomes clearer and seems to be moving in same direction. The blue and green arrows shows he direction of both Nifty Index and 5 day SMA of mood index. Great!!! Mood index after all gives a good 15 days of advance notice to traders and investors about the impending change in trend. Although the mood index or any other index cannot predict the exact date on which the index will change direction, it is still a great leading indicator. If used with other standard technical indicators.
This could safe traders and investors from big losses and also show great opportunity for long position at appropriate time.