Fundamentals and Sentiment

From Volatility.RED

In this Wiki, we will explore what both fundamentals and sentiment are and build and expand on previous information from our Fundamental Analysis Wiki.

This Wiki is part of our comprehensive Fundamental Analysis Wiki. Be sure to check that out HERE.

Fundamentals and Sentiment

You may recall that the fundamentals, particularly for FX trading, tend to revolve around the Central banks of each nation and the expectations of the market for what that bank will do next with its interest rate policies. The Central banks use economic indicators to determine the state of the economy and then implement the various tools they have at their disposal. They do this with the hopes of improving the indicators they deem important to keep the economy stable and in line with their policy mandates.

To explain this effectively we have to break the concepts of this analysis down into two distinct parts:

  1. Fundamentals: The first part is the underlying fundamentals that we talked quite a lot about in previous sections. Fundamentals are the big macro picture for the economy being measured. For example, if you are trading the Australian Dollar then you need to understand the economic situation of Australia and what the central bank of Australia is concerned with.
  2. Sentiment: What we haven’t looked at too much are the things that are driving the price right this moment in the here and now. This is called sentiment and is the most important thing you need to concern yourself with if you are considering becoming or are a day trader.

Therefore, we have two core elements that we must be in tune with at all times; the underlying fundamentals and the ever-changing sentiment. This is an extremely important distinction to make so make sure that you have your thinking cap on as you go through this section.

The simplest way to understand the difference between fundamentals and sentiment is to imagine that the fundamentals are the big picture. This big picture is things that don’t change very often and are the things that are driving prices over weeks and months. Sentiment, on the other hand, are the short-term things that the market participants are obsessing over that are driving prices over hours and days in the current session and beyond.

Of course, sentiment can take over in the short term and move the price against the big picture fundamental trend. However, as long as the core principles remain in play the trend will typically resume at some point when the sentiment wares off and fades away from the market's memory.

The market tends to have a short-term memory when it comes to sentiment. This means that the sentiment must be very strong to drive prices for more than a couple of days. It's pretty common for the market to get really concerned with a specific news item and move prices hard in one trading session only to completely reverse that move the next session because there is some new piece of information that the market is focussing on instead.

Understanding that the sentiment can be with or against the big picture fundamentals is key. But the best trades will always be when the current sentiment is in line with the big picture fundamentals. This is because this situation will cause the most number of market participants to trade in the same direction at the same time. However, it's also key to understand that you can make a lot of pips when the sentiment is opposite the fundamentals because the market tends to forget about the fundamentals when there is a reason to think differently.

Understanding these two concepts and how they work provides us with the foundations for identifying various trading opportunities throughout the trading day. For example, some traders use the short-term sentiment as an opportunity to trade the longer-term trend at a much more attractive price. This means that these traders wait for a situation when the sentiment is actually opposite to that of the fundamental trend. This causes prices to correct in the short term setting up nice opportunities to get in the fundamental trend at a better price. At the same time, other traders may take advantage of the counter-trend sentiment and trade in line with it to make a quick profit.

As we have already seen, fundamentals are very important to successful trading but there are other core areas that must be developed if a trader is to become successful for the long run; Fundamental Analysis, Sentiment Analysis, Technical Analysis, Risk Management, and Trading psychology. The goal should be to get yourself to a point where you are proficient in all these areas so that you can achieve your goals.

One of the core things that most traders will likely need to improve is something called "Conviction". Conviction simply means having confidence in your trading. Traders use conviction to determine how good a possible trade is and how likely it is for that trade to yield a profit. With time and practice your conviction levels will naturally increase making your trading comfortable and seem like second nature.

If you have a high level of conviction in a trade based on all the things that you understand to be true then generally your chance of success is much higher. If you combine this with your own personal research for a specific opportunity then you have a chance at increasing your conviction level.

Traders that do not pay attention to their conviction levels, or simply don’t know how to increase their conviction levels, have very little chance of success. You must constantly be aware of your conviction, measure it, and control it in order to achieve a high level of success. Keep this in mind while researching a trade to determine both the underlying fundamentals and the short-term sentiment because your conviction level will directly influence your level of Trading psychology while you are in a position. The more factual reasons you can find to support a position, the more comfortable you will feel overall because you will know that you have done all you could to give yourself the best chance of success.

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