Introduction to Sentiment Trading

In this Wiki, we will introduce the concepts of Market Sentiment and Sentiment Analysis in the Forex Market. This build is the foundational information for the Sentiment Analysis Wiki and will set the foundation for all other Sentiment Analysis and applying Sentiment to the Forex market successfully.

This Wiki is a part of our Essential Forex Trading Guide. Be sure to check that out HERE.

Introduction to Sentiment

In this Wiki, we will expand on the concept of market sentiment that we touched on in the Fundamental Analysis Wiki.

Sentiment can be best explained by describing it as the Mood of the market right now in the present tense. Just like the moods of individuals, sentiment can change quickly and for a variety of reasons. One of the best ways to view the market is as a giant living person because it is essentially made of millions and millions of people all thinking, feeling, and reacting at the same time in their own unique way. The market is simply an aggregate of all of those thoughts, feelings, and actions that traders do and take.

If you are a short-term trader then the sentiment is going to be your primary concern when analyzing the markets and trying to identify a trading opportunity. Having the current market sentiment in line with the big picture fundamental trend will offer some of the best trading opportunities you can find.

There are no mechanical rules regarding sentiment. It can last an hour, a day, or even several months depending on what is causing it and how relevant the market believes the cause for the sentiment is to the current economic situation.

An interesting thing about sentiment is that sometimes the market reaction to a certain event will be quite strong but then a few weeks later the exact same scenario will occur and the market will hardly have the slightest move in reaction. This can cause a lot of frustration for traders that are not staying properly tuned into the market. A lot of what will cause things to change with sentiment is the Expectations from the market. The market will always react more to information that is not known than information that is already known. Once the information is known to the markets then the reaction or price move will be far less because the market has already attempted to price in the information.

You may be thinking that sentiment is going to be quite tricky to fully understand. Once you understand the concept a little deeper, and most importantly the process for identifying it, your skills and intuition will improve dramatically to the point where you will find it a straightforward process to identify the sentiment and the reasons behind a particular price move.

The concept of sentiment is similar to the underlying fundamentals or Fundamental Analysis. One of the most important aspects of your trading is to identify the reasons why the market is moving in a certain way. The underlying fundamentals tell you why something is moving a certain way over the long term. The sentiment tells you why things are moving in the short term or in the here and now. This is why sentiment is so important to day traders and scalpers. No matter what or how you are trading your first goal should be to identify the prevailing sentiment in the market you are trading in.

Sentiment is a form of Fundamental Analysis but for the short term rather than the longer-term picture. As we have already looked at, the golden rule of sentiment is that the more something is known the less of an impact it will generally have. This is something that you should always try to keep in mind when trying to identify the sentiment and the expected market reaction caused by that sentiment.

Sometimes the market will be focused on one thing but then something else happens and the first thing is instantly forgotten. On other occasions, the sentiment will last for weeks as the market becomes more and more obsessed with a certain piece of information. This is one of the reasons you should always be thinking of the market as a living and breathing person because very often the market will display human characteristics of fear, greed, and irrational behaviour.

Because sentiment can be many things at different times this means that the markets will never ever be 100% predictable. However, imagine if you could tell when the market was behaving in a certain unpredictable manner, you would be able to just avoid these times which would stop you from giving back your profits that you worked so hard to generate during the good times.

What we will now spend the most time on in this Wiki is taking a look at what types of moods the market experiences and some of the most common reasons that price is driven one way or the other during an average trading session.

Sentiment in Forex Trading

Sentiment can be best explained by describing it as the "Mood" of the market right now in the current trading session.

The concept of sentiment is similar to underlying fundamentals. One of the most important aspects to your trading is to identify the reasons why the market is moving in a certain way. The underlying fundamentals tell you why something is moving a certain way over the medium to long term. The sentiment tells you why things are moving in the short term. Sentiment is the here and now. This is why sentiment is so important to day traders and scalpers. No matter what or how you are trading your first goal should be to identify the prevailing sentiment in the market you are active in.

Sentiment Golden Rule

Sentiment is a form of Fundamental Analysis but for the short term rather than the longer term picture. ‘’’The golden rule of sentiment is that the more something is known to the market the less of an impact it will generally have.’’’ This is something that you might want to keep in mind when trying to identify the sentiment and the expected market reaction caused by that sentiment.

Just like the moods of individual people, sentiment in the Forex market can change quickly and for a variety of reasons. Just think of the Forex market as a giant living person. Essentially, it is made of millions and millions of people all thinking, feeling, and reacting in the same time in their own unique way. The Forex market is simply an aggregate of all of those thoughts, feelings, and actions.

If you are a short term trader then understanding the current sentiment is a primary concern when analyzing the Forex market and trying to identify a trading opportunity on individual currency pairs. Your primary concern is going to be on the sentiment because any change in the sentiment environment can have a very large impact on any trades that you may have open at any specific time. It could also change in a way that presents you with a new trading opportunity.

Let’s look at an example of what we are talking about here.

Sentiment Trading Example

Let’s say that you are long the AUDUSD currency pair (long means that you have bought the pair and are expecting the price to move higher). If, for example, the Reserve Bank of Australia comes out and unexpectantly cuts their interest rate while you are in the trade; what will you do?

For most people, especially technical traders, they will just get stopped out when the price drops like a stone. The price will drop because the market was not expecting a surprise rate cut. We know that cutting the interest rate is typically a negative thing for the currency in question and if it was unexpected then this will cause the reaction to be much stronger than if it was expected.

Also, this assumes that the trader had a stop loss attached to their position which we can say for certain is not always the case. Professional traders use stop losses in almost all cases. Monkeys don’t use stop losses because…..well, they are monkeys and don’t know any better. Be a professional and not a monkey!

Now, because you know that a surprise rate cut is a very negative thing for the Australian Dollar, and you are monitoring the sentiment, you can exit out of your position potentially before your stop gets hit. Then you can look to make up that loss by going short and maybe even squeak out a profit too.

Do you see how big of an advantage you have by paying attention and being in tune to the sentiment?

The technical traders get stopped out and have no idea why price went against them. But you know what the sentiment is, and how to react, so you can get out of your long and flip to being short a long before the technical traders figure out what has happened.

Knowing the sentiment can save you money and make you money! But you just need to know what certain sentiments will do to a currency. That will take some time and experience but it will definitely be clearer by the time you get through the end of this guide.

Fundamentals versus Sentiment

Let’s first think of fundamentals as the big macro picture of the health of an economy. If the particular economy is performing well, people have jobs, economic data is strong, and interest rates are rising then we would expect the currency of that nation to move higher over the long run.

People and financial companies want to invest in growing and stable economies that are performing well. In order to do that it means that they will need to buy the local currency of that economy in order to invest in it.

For example, if the United States of America is currently a booming economy then foreign investors will want to invest in the United States to make a strong return on investment. In order to do that they must first sell their native currency and buy the U.S. Dollar. If enough investors move their money into the United States then it can cause the value of the U.S. dollar to rise over time.

This is a perfect scenario example but we know that currency prices just don’t go up or down in a straight line forever. It would make the job of traders much easier if they did but that’s unfortunately not the reality.

Even though the big picture fundamental outlook may be overall positive, there will be many days or even weeks when the price actually goes down against the long term fundamental trend. In these times this means that the ‘’“ Sentiment of the day or trading session”’’ has turned against the big picture fundamental trend. There are a variety of reasons that this happens but the key is that some piece of information forced price to be temporarily out of line with the big picture fundamentals.

Perfect Sentiment Trades

The very best sentiment trades happen when the current sentiment of the current trading session is in line with the big picture fundamentals. Said another way; the mood of the market today compliments the long term fundamental economic direction.

These are great trades because you have the power of the longer term investors who are using the fundamentals and the shorter term hedge fund traders using the sentiment to get into or out of their trades. Together they are all happily pushing the price in the same direction which can make for some great price action to take advantage of.

This is a time when you can make a lot of pips very quickly with trades that might not try to go against you very much if you have picked a good entry point.

The very best sentiment trades look like the following:

• If the fundamentals are ‘’“positive”’’ and the sentiment of the day is ‘’“positive”’’ then you can look to buy all day long at good buy points (however you define a good buy point). This is where you might want to use some well thought out Technical Analysis or Price Action Analysis to time your entry.
• If the fundamentals are ‘’“negative”’’ and the sentiment of the day is ‘’“negative”’’ then selling or going short all day long at good sell points is a smart idea. Again, Technical Analysis and Price Action Analysis will help you time your entries.

These are the type of trades that tend to last longer and move more in terms of pips because most of the market participants are thinking of trading in the same way.

Counter-Sentiment Trading Opportunities

There is another situation where the sentiment and the fundamentals are actually opposite each other. These are counter-sentiment trading opportunities because they are kind of like saying counter trend to the fundamentals. But this doesn’t mean you can’t trade these situations.

‘’’Counter-sentiment trading opportunities look like the following:’’’

If the fundamentals are ‘’“Positive”’’ and sentiment is ‘’“Negative”’’ you have 2 options:

1. Allow the negative sentiment to bring price back to where it makes fundamental sense to start buying again in line with the big picture (think buy the dip value traders).
2. Trade the negative sentiment short against the positive fundamentals. This is where knowing how strong the sentiment is will help you make some profitable trades against the big picture fundamentals. These tend to be shorter term trades with higher risk.

If the fundamentals are ‘’“Negative”’’ and sentiment is ‘’“Positive”’’ you have 2 options:

1. Allow the positive sentiment to bring price back up to where it makes fundamental sense to start selling/shorting again in line with the negative fundamental trend.
2. Trade the positive sentiment long against the negative fundamentals. This is where knowing how strong the sentiment is will help you make some profitable trades against the big picture fundamentals. These tend to be shorter term trades with higher risk.

The sentiment trades that are against the [[Fundamental_Analysis | fundamentals] tend to be the trickiest. These are the trades you might want to stay away from until you are comfortable that you have a high level of skill when it comes to trading and understanding the sentiment situation that is active in a live market.

Sentiment is caused by fundamental economic data and market-moving information that could come in many forms. These situations are exactly what this whole Wiki is going to explore and uncover.

Challenges with Sentiment Trading

There are no mechanical rules regarding how to trade sentiment. Unfortunately, it’s not black and white like Technical Analysis is. Trading sentiment is more of skill that is honed and perfected by spending time with the market and getting to know its moods and behaviours that it has when certain events that happen.

Sentiment can last for an hour, a day, or even months depending on what is causing it and how relevant the market believes the cause for the sentiment is to the current economic situation. It’s really all about what the market expectation of an event is that creates the initial sentiment. Once the news is out the market will then create a new sentiment based on what actually happened with news event.

An interesting thing about sentiment is that sometimes the market reaction to a certain event will be quite strong but then a few weeks later the exact same scenario will occur and the market will hardly produce the slightest move. The Forex market tends to become desensitized to information the more that it hears it. This can cause a lot of frustration for traders that are not staying properly tuned into what is currently driving prices in the Forex market.

A lot of what will cause things to change with sentiment is what the expectations from the market are. As we know, ‘’’the market will always react more to information that is not known or is unexpected.’’’ Once the information is known to the market then the price swings will become far less because the market has attempted to price in the information already. Old news is old news and the market continually wants to be given new information to drive prices.

Sometimes the market will be focused on one thing but then something else happens and the original thing the market was focused on is instantly forgotten. On other occasions, the sentiment will last for weeks as the market becomes more and more obsessed with a certain piece of information as it continually tries to price that information in.

One way to try and understand the Forex market is to think of the market as a living breathing person because it will often display human emotions of fear, greed, and irrational behaviour.

Related Wikis

Readers of Introduction to Sentiment Trading also viewed:

• Sentiment Analysis
• Fundamental Analysis
• Fundamental and Sentiment Trading Strategies
• Pre-Trade_Considerations
• Conviction in your Trading