How To Master Sentiment Analysis In Forex Trading
Sentiment analysis is an important indicator when it comes to understanding how other traders feel about the market. Read on to learn more.
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- What is Market Sentiment?
- What is Sentiment Analysis?
- Sentiment Analysis in Forex
- How to Measure Market Sentiment
- Limitations of Market Sentiment
What Is Market Sentiment?
From behind your computer or smartphone screen, all you see of the “market” is a flurry of numbers and chart data. But your trades don’t take place in a technical vacuum. With each order, you become an active participant in your chosen market and contribute to the overall sentiment of the trading community.
Market sentiment describes the overall feeling of traders towards a given asset at a given time. At a base level, if this outlook is positive, price action is also bullish as more traders open long positions. If negative, traders are more likely to close their positions and feed a bearish downturn.
More generally, market sentiment can refer to the risk tolerance of investors according to the state of the economy. This then dictates which assets are favoured. In a “Risk-On” environment, the economy is stable, so investors are likely to chase profits in volatile assets. In a “Risk-Off” environment where the economy is struggling, investors will choose Safe Haven assets for security.
What Is Sentiment Analysis?
Sentiment analysis sits somewhere between fundamental analysis and technical analysis. It is the method whereby traders identify this mood of markets to predict future price movement.
Sentiment and fundamental analysis sometimes converge in their signals when traders react to the news around macroeconomic events. However, this isn’t always the case. Market sentiment can be more volatile than fundamental analysis might otherwise indicate because it can move independently of fundamental signals, and sometimes even against them.
Sentiment and technical analysis partially overlap with their use of indicators. The difference is that sentiment indicators reflect the present outlook of traders in the market, whereas technical indicators offer more general insights into price action.
Sentiment Analysis In Forex
Of course, sentiment analysis can help you stay abreast of price trends for your chosen asset. With forex, sentiment becomes particularly significant because you deal with not one but two assets in your currency pair. The price movement of your chosen pair will hinge upon the contrast in outlook towards each currency at a given time. For example, during periods of economic uncertainty, Safe Haven currencies (such as USD, JPY, or CHF) will attract more investors. On the other hand, when USD strengthens, commodity-related currencies (such as RUB) will be worth less.
In this sense, your understanding of forex sentiment depends upon your knowledge of your chosen currencies and the way they function in the global economy. This is why we recommend you start with a single currency pair to keep things simple if you’re a forex beginner!
How to Measure Market Sentiment
Certain aspects of technical analysis, such as trend spotting, are useful for gauging bullish or bearish market sentiment. However, there are a number of other indicators specifically designed to help you measure the mood of the markets.
COT Report – The Commitment of Traders Report is released by the Commodities Futures Trading Commission every week and provides a summary of trading positions on a given asset. It divides traders into groups: commercial (those with a stake in the underlying asset) and non-commercial (those speculating for profit). The respective positions of these groups provide insights into present market sentiment. Generally speaking, commercial traders tend to be most active around trend reversals, whilst non-commercial traders tend to ride the trends.
PCR – The Put/Call Ratio is, simply put, an indicator that signals bullish (below 1) or bearish (above 1) trends over a certain time. Extreme highs or lows can suggest an imminent price reversal due to overbought or oversold conditions, but this is not always the case, as will be explained below.
Limitations of Market Sentiment
Like any form of analysis, sentiment analysis does not provide 100% fool-proof trading signals. Sentiment indicators are most sound when they confirm trends, but less reliable when it comes to pinpointing when reversals will happen. This is because ultimately, interpretation of market mood is entirely subjective.
As always, it’s worth corroborating your ideas with multiple forms of analysis. RSI or Moving Average indicators are useful for the confirmation of trends. Meanwhile, keeping an eye on fundamentals helps you anticipate how your currency pair is expected to perform in the long term.
Always remember that you are dealing with a live market. It can be flippant, unpredictable, and sentimental, and nothing is set in stone.