Exploring social sentiment as a trading signal indicator

Investor sentiment may erroneously impact stock valuations, leading to overpricing when investors are over-optimism and vice versa.

Exploring social sentiment as a trading signal indicator

Mar 9, 2022 - Aaron undefined

6:41 PM


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Image credit: Freepik

Key takeaways

  • Social sentiment score analyzes aggregated social media data to help users understand how underlying instruments (stocks or crypto) are performing in the eyes of the public.
  • Social sentiment score serves as a proxy to gauge the relative valuation of an instrument compared to normal social sentiment level, giving an indication of whether the social sentiment is over-priced or over-underpriced.
  • This gives users an idea of how a publicly-traded instrument's price might perform.

How Social Sentiment Score could be used to facilitate investment decisions

Social sentiment scores are compiled from information users post publicly to Twitter and Stocktwits. If the social sentiment score exceeds or falls below normal sentiment score levels, corresponding price correction may take place in the next 6-12 hours in which prices converges to price levels to address any over or undervaluations due to excessive levels of sentiment.

From observations, trading signals tend to manifest when:

  • Social sentiment level is above normal sentiment distribution (i.e. Over-optimistic) => Price drops in the next 6-12 hours
  • Social sentiment level is below normal sentiment distribution (i.e. Over-pessimistic) => Price increases in the next 6-12 hours

Based on these, excessive sentiment can be divided into positive and warning signals with varing magnitudes depending on their direction and degree of deviation from the normal sentiment distribution.

Below is a demonstration of how this could work to generate trading signals.

Limitations of Social Sentiment Score Model

  • As illustrated, there can be lagging and diminishing effects using the social sentiment score model to gauge stock price changes before and after weekends or holidays (non-trading hours), since stock markets operate in trading hours only, whilst social sentiment is around 24-7;
  • Succeeding over-optimistic or over pessimistic social sentiment levels may have unexpected price change from our usual observations, with varying magnitudes of decrement or increment; and
  • Succeeding over-optimistic and over-pessimistic social sentiment levels may reduce the corresponding magnitudes of corresponding price corrections in the following periods.

Nevertheless, social sentiment score, to a certain extent, can be used as a reliable leading indicator measurable to provide hints as to where the price trend will head next, and this could provide investors with some indicators to guide their investment strategies as they anticipate future market conditions.