Common Pitfalls in Using Sentiment Data

Have you ever seen a chart or indicator that says "everyone is bullish" or "the crowd is extremely fearful" and thought, You think you've discovered the next move? A significant number of traders or investors fall under that umbrella. Sentiment data is exciting because it draws from the psychological thoughts of the market or crowd behaviour (the mass).

Now, here is the point: misuse of sentiment measures can be equally harmful as dismissing the entire sentiment idea. If you have ever used or been influenced by a sentiment tool, you are not alone. In this article, we will outline the most significant mistakes everyone makes when using sentiment measures or asserting them (for example) into the decision-making process, and what you can do to avoid the mistakes and make better trading decisions.

Misinterpreting Sentiment for Direction

One of the biggest mistakes is assuming sentiment is direction. Meaning, sentiment is measured on how traders feel, not necessarily what the market will do next. Extreme bullishness or extreme bearishness can last far longer than you imagine. A good example would be you can have an "overbought" market that continues to climb or an "oversold" market that continues to drop. Using sentiment measures as a buy or sell signal can lead to considerable frustration.

Using All Sentiment Measurements in the Same?  

There are different types of sentiment data to consider: retail & institutional positioning, COT reports (changes from prior position), VIX or volatility (with ETF), sentiment in news articles (news tone can help), and even social media chatter (social media sentiment).

There are different groups of people being measured. A common mistake is mixing them up and using them interchangeably. For instance, retail positions often reflect a counter to what the trader masses are doing (the crowd), while institutional positions require a more intuitive reading. It is essential to understand the source and context of each tool.

Mistaking lagging sentiment data for real-time information

Sentiment data is rarely instantaneous. For example, Commitment of Traders reports are published with a lag, surveys or polls take time to collect, and even social media analysis is slower than the current price moves. A trader who believes these reports show "what's going on right now" and trades off that data is trading lagging data. The point, again, is to treat sentiment data as background information, not a timing tool.

Over-committing to extremes

For example, while extreme sentiment can highlight a top or a bottom, those signals are not actionable instantaneously. The classic error is to short a market because the sentiment reading is high enough to indicate that optimism has peaked, or to buy into a doom-and-gloom story. After all, pessimism has reached an extreme.

Extremes can occur in well-trended markets and will. Trading against a strong trend without evidence of a behaviour change is the number one way to lose money. Extremes should be conditions to monitor closely, as an alert, not immediately trade off on the readings.

Thinking sentiment is enough on its own

My experience is that many traders want to use sentiment in a vacuum. This rarely goes well. Sentiment data provides the most outstanding value when put together with other factors—such as technical levels, momentum, and/or fundamental drivers. Without other confirming factors, you are essentially trading on feelings rather than evidence.

For instance, sentiment can indicate weakness, but unless the price action confirms the sentiment indicator told you when price action created a clear turn in the price action (a reversal or a break of support), they are likely to bet early against the trend.

Assuming retail positioning is actionable

Broker data on retail trader positioning (how many retail traders are long vs short, for example) can undoubtedly be helpful, but it is often misconstrued. Traders may be inclined to think, "Well, if 80% of retail is long, I'd better be short." While it's true that retail crowds can often get it wrong on the side of a sustained move, they can get it wrong on that side for weeks. One of the most common, expensive mistakes traders make is betting against retail too early.

Confusing Noise with Signal

Another error is spending too much time/giving too much weight to sentiment measures that are too noisy. Things such as randomly generated opinions from social media or the spikes created by headlines. While these indicators may sometimes measure sentiment about mood changes, they more often represent noise and do not better inform the trader's action. It is a skill that a lot of traders don't grasp when separating hype from fundamental shifts.

Ignoring the Market Environment

Sentiment data does not live in a vacuum. An "extreme" reading does not mean much unless we understand the broader context - i.e., if we are in a strong bull market and retail is "extremely bullish," this is probably just a sign of healthy market participation, rather than a danger of reversal. Conversely, if we have "extreme bullish" readings when in a fragile, overextended market, we may have reason to act. Context is what turns raw data into useful information.

Thinking of Sentiment as a Crystal Ball

The largest mistake traders make is believing that sentiment will definitely reveal what the future holds. The market is not a simple system; it is multifaceted, and sentiment in the market is affected by many factors that range from reports on economic conditions to policy decisions to geopolitics, etc. It is not that sentiment is not useful, and sometimes valuable coloration is provided along the way, but sentiment ultimately does not provide guarantees.

Treating sentiment as gospel will often find the trader chasing false flags. A more intelligent way to think about sentiment is by placing it within the context of a larger decision-making framework.

Not Backtesting or Validating

Many traders dive into using sentiment indicators without any backtesting. The absence of backtesting can lead traders to become susceptible to false patterns that don't persist over time. Validation refers to examining how a past-cycle of sentiment signal acted during past market dynamics. Validation helps narrow down unreliable signals and ultimately builds confidence in the trader's decision-making process.

Overconfidence After One Successful Trade

Sentiment may result in a significant win, such as calling the top when the entire market was euphoric in a given direction. However, one win tends to create overconfidence in the trader. After the first success, traders will rely too heavily on sentiment to make all their decisions, and things will turn ugly during a volatile period in the market. Overconfidence after one win is one of the fastest ways to give back the profits.

Best Practices in Rating Sentiment

To leverage sentiment data effectively, do not rely solely on sentiment data:

• Have compatible technical and fundamental analysis.

• Treat sentiment only for context, and not as a single source of trigger.

• Don't interact with extreme sentiment measures without waiting for confirmation.

• Know the source and bias of individual sentiment measures.

• Backtest traded strategies to help distinguish the real from the false, and

• Always consider risk management; never bet the farm solely based on sentiment.

Summary

Sentiment data can be a powerful ally in trading and investing, only if used correctly! The most significant pitfalls within sentiment data come from not fully understanding what sentiment really shows, with traders expecting an immediate share price response to the sentiment data, and from an overreliance on sentiment as the only measure.

Respecting these limitations, combined with a solid set of technical and fundamental analysis, and remaining disciplined in a risk-managed approach, will help turn sentiment into a helpful resource and not a detrimental distraction.

At the end of the day, do not let the emotion of the crowd drag you into a bad trade! At best, assume sentiment serves as a lens, rather than a solitary crystal ball, to better position oneself in the current market with greater clarity and care.