Warren Buffett famously said, "Be fearful when others are greedy and greedy when others are fearful." Sentiment timing puts this wisdom into practice by measuring investor emotions and using extremes to time market entries and exits. This guide will teach you how to read market sentiment and use it to improve your trading timing.
What is Sentiment Timing?
Sentiment timing measures how bullish or bearish investors feel about the market and uses this information to make contrarian trading decisions. The underlying principle is that extreme sentiment often marks turning points. When everyone is bullish, the market is often near a top. When everyone is bearish, it is often near a bottom.
The contrarian edge: Markets are driven by emotion in the short term. When sentiment reaches extremes, most of the buying or selling has already occurred, leaving the market primed for a reversal. Sentiment indicators help you identify these extremes objectively.
Key Sentiment Indicators
1. Put/Call Ratio
The put/call ratio measures the volume of put options traded relative to call options.
- Ratio above 1.0: More puts than calls, indicates fear (potentially bullish)
- Ratio below 0.7: More calls than puts, indicates greed (potentially bearish)
- Extreme readings (above 1.3 or below 0.5): Strong contrarian signals
Put/Call Ratio Trading
- 10-day moving average of equity put/call ratio spikes above 0.85
- This indicates heavy put buying (fear)
- Contrarian buy signal, especially if price is near support
- Wait for ratio to peak and start declining before entering
2. AAII Investor Sentiment Survey
Weekly survey asking individual investors if they are bullish, bearish, or neutral.
- Bulls above 50%: Excessive optimism, be cautious
- Bears above 50%: Excessive pessimism, look for buying opportunities
- Bull-bear spread: Extreme readings (above +30 or below -20) are significant
3. Fear and Greed Index
Composite indicator that combines multiple sentiment measures into a single reading from 0 (extreme fear) to 100 (extreme greed).
- 0-25: Extreme fear, potential buying opportunity
- 25-45: Fear
- 45-55: Neutral
- 55-75: Greed
- 75-100: Extreme greed, potential selling opportunity
4. Investors Intelligence Survey
Measures sentiment among newsletter writers and market advisors.
- Bulls above 60%: Excessive optimism
- Bulls below 40%: Excessive pessimism
- Bears above 45%: Strong contrarian buy signal
5. Social Media Sentiment
Modern sentiment analysis tracks mentions and sentiment on social platforms.
- Spike in bullish mentions often precedes short-term tops
- Spike in bearish mentions often precedes bounces
- Use as confirmation, not primary signal
Sentiment Timing Strategies
1. Extreme Fear Strategy
Buy when sentiment reaches extreme fear levels.
Fear Entry Criteria
- Put/call ratio above 1.0 (10-day average)
- AAII bears above 45%
- Fear and Greed Index below 25
- VIX elevated (above 25)
When multiple fear indicators align, it is a strong buy signal. Wait for price to stabilize before entering.
2. Extreme Greed Strategy
Reduce exposure or hedge when sentiment reaches extreme optimism.
- Put/call ratio below 0.65
- AAII bulls above 50%
- Fear and Greed Index above 75
- Margin debt at record highs
3. Sentiment Divergence Strategy
Look for divergences between price and sentiment.
- Bullish divergence: Price makes new low but sentiment does not get more bearish
- Bearish divergence: Price makes new high but bullish sentiment is not expanding
- These divergences often precede trend changes
4. Smart Money vs. Dumb Money
Track whether "smart money" (institutional investors) diverges from "dumb money" (retail investors).
- Commercial hedger positions in futures (COT report)
- Insider buying and selling patterns
- When smart money diverges from dumb money, follow the smart money
Building a Sentiment Timing System
- Select your indicators: Choose 3-5 sentiment measures to track regularly
- Define extremes: Set specific thresholds for bullish and bearish extremes
- Create a composite: Weight your indicators into a single sentiment score
- Wait for confirmation: Do not act on sentiment alone; wait for price confirmation
- Time your entry: Use technical analysis to pinpoint entry within sentiment windows
- Manage risk: Even with extreme sentiment, use stops; sentiment can stay extreme longer than expected
Sentiment Reading Framework
Use this framework to interpret current sentiment conditions:
Maximum opportunity zones:
- Extreme fear + price at support + oversold technicals = Strong buy zone
- Extreme greed + price at resistance + overbought technicals = Strong sell zone
The most profitable trades occur when sentiment, price, and technicals all align.
Common Sentiment Timing Mistakes
- Acting too early: Sentiment can stay extreme for extended periods. Wait for price confirmation
- Ignoring the trend: In strong trends, extreme sentiment may not mark the end
- Single indicator reliance: Use multiple sentiment measures for confirmation
- Confusing noise with signal: Daily sentiment swings are noise; focus on weekly extremes
- No price confirmation: Always wait for price action to confirm sentiment extremes
Combining Sentiment with Other Analysis
Sentiment timing works best when integrated with other methods:
- Technical analysis: Use chart patterns and support/resistance with sentiment extremes
- Volatility: High VIX plus extreme bearish sentiment is a powerful buy signal
- Seasonality: Sentiment extremes during favorable seasonal periods are stronger signals
- Fundamentals: Extreme pessimism in quality companies offers the best opportunities
Real-Time Sentiment Monitoring
Set up a sentiment dashboard that tracks:
- Daily put/call ratios
- Weekly AAII and Investors Intelligence surveys
- Daily Fear and Greed readings
- VIX levels and trends
- Social media sentiment trends
Track Your Sentiment-Based Trades
Pro Trader Dashboard helps you analyze how your trades perform in different sentiment environments. See whether you are effectively buying fear and selling greed.
Summary
Sentiment timing is a powerful contrarian approach that capitalizes on the emotional extremes of market participants. By tracking indicators like the put/call ratio, AAII survey, and Fear and Greed Index, you can identify when fear or greed has reached levels that often precede market reversals. Remember to always confirm sentiment signals with price action and other technical factors. The best opportunities arise when extreme sentiment aligns with favorable price patterns and fundamentals.
Continue your timing education with our guides on volatility timing and economic cycle timing.