Did you know that 80 percent of retail forex traders lose money yet those who continuously make profits have a common secret? They know the market psychology. Studying to employ sentiment analysis in forex may take your trading experience to a whole new level as it tells you what the masses believe and how they feel regarding the direction of currencies.
Sentiment analysis on forex extends farther than economic indicators and technical charts. It goes into the moveable mass of emotions and attitudes of the market participants, providing you with insights that the price action by itself would never give you.
What Is FOREX Market Sentiment?
Market sentiment denotes the general feeling or emotional coloring by the traders on certain currency pairings. Just imagine the psychology of the market at any time.
Workers have a positive view of a future of a currency; that is when we are witnessing the bullish sentiment. Bearish sentiment, on the other hand, can be achieved with pessimism of pessimism. It is more of a psychological state and usually influences price action as powerfully as the economic fundamentals.
The forex market is the largest financial market in the world because it handles a volume of more than 7.5 trillion dollars daily. In this giant ecosystem, sentiment analysis can unravel the why behind the price direction which on some occasions appears to be enigmatic to rational expectations.
The importance of Sentiment Analysis in Currency Trading
Market Reversals Prediction
When reading sentiment is extreme, this is a common indicator of reversal trends. When 90 percent of traders are in long position in EUR/USD, e.g., it may become a hint at the overbought situation without so many buyers available to force the prices to grow.
This contrarian philosophy prevails because markets require new entrants to continue their trends. When sentiment is at extreme levels it takes away the fuel which is required to move in that direction further.
Affirming Prevalent Trends
Sentiment analysis also checks existing trends. When there is a relationship involving both technical analysis (which indicates the price of GBP/USD is heading in an upward direction) and sentiment indicators that demonstrate more and more bullish sentiment, this correlation will support your belief in the trading scenario.
Risk Management Improvement
Crowd psychology can assist in measuring trade risk with more accuracy. The high bullish language over a currency pair may indicate a crowded position, which may imply steep moves that can lead to stop-out signs.
Important Sentiment Indicators That Every Trader Should Learn
Commitment of Traders (COT) Report
The Commodity Futures Trading Commission weekly publishing of the COT report has been able to divulge positioning of various categories of traders. Traders (hedgers), big speculators and little traders all offer different trader intelligence.
Big speculators tend to cause significant trends whereas commercial traders normally hedge against the prices. In cases where such groups demonstrate extreme positioning, there can be chance of reversals.
Retail Sentiment Indicator
The percentage of longs against short positions of clients of major currency pairs is being exhibited by many brokers. When 75 percent of retail traders submit buy orders on EUR/USD this forms a sentiment reading and experienced traders will learn to read it.
Such indicators are useful in contrarian analysis because retail traders tend to behave like a flock.
Fear and Greed Index
It is a composite indicator that gauzes market sentiments on various data such as volatility, volume of trades, and surveyed results. Excessive fear levels may introduce us to oversold markets and excessive greed may indicate overbought markets.
Sentiment Analysis in Forex Trading Strategies
The Contrarian Way
Contrarian trading entails trading against the direction of the market. Contrarian traders take sides against the strong readings when sentiment indicators are excessive.
As an example, when sentiment signals are released to show that 85 percent of traders are bearish on USD/JPY, a contrarian could decide to seek buying opportunities because that level of pessimism has already caused the market to become oversold.
Trend Confirmation Strategy
Confirm pre-existing technical and basic bells and whistles using sentiment analysis. When you have the technical analysis and sentiment indicators pointing in the same direction (ie. both are expecting a bullish EUR/GBP setup), then you have an even stronger reason to think you are making the correct choice in your trade.
Divergence Trading
Look out on price/ sentiment discontinuities. As long as there is divergence and the EUR/USD rises accompanied with more and more negative sentiment, the potential implication could be that the currency pair may soon decline.
Resources and Tools of PopSenze
Broker Sentiment Data
A significant number of major forex brokers display data in real time which indicates the percentage of their clients who are long or short on major pairs. Though this is merely a small sample of the larger market, it is a good source of information on the behavior of retail traders.
The Social Media Monitoring
To gain an edge over the others, advanced traders follow the form of discussion around forex on social networks, online trading forums, and financial news portals. An early sentiment can be signalled by abrupt changes in either form of negative or positive commentary.
News sentiment analysis
News articles, economic reports and central bank communications are now being analysed by automated systems to see what the sentiment is. Such programs analyze large quantities of data and with speed better than human traders and give sentiment updates instantaneously.
Mixing Sentiment with Other Analyses
Technical Analysis Integration
To get user sentiment right, it should be used along with technical and fundamental analysis. Technical analysis could suggest that it is overbought and fundamental analysis may suggest that the economic underpinning is there to warrant the initiative.
Risk Adjusted Position Sizing
Account sentiment in position sizing. It might be wise to scale in position sizes in high emotion markets with very high readings of sentiment so as to mitigate the volatility and the risk of proper reversal.
Timing of the Markets Enhancement
Sentiments indicators assist entry and exit timing. Although a good basic thesis is half the battle, trading sentiment at extremes can generate superior risk compensated returns.
Application to the real world: Trading USD / JPY with Sentiment
Take this week when technical FX analysis indicated that USD/JPY had become oversold, yet sentiment in the retail markets indicated that 70 percent of retail traders were still selling the pair. This polar bearish tone, coupled with over-sold technical landscape, presented a contrarian traders buying opportunity that carried a high likelihood of enjoying success.
The trick was to allow sentiment to run to extremes, and then to act on the technical signal. Merging the two analyses would yield traders more favorable entry points with a better ratio of risk to reward.
Sentiment Analysis Misuses
Single indicators over-dependence
Do not make trading decisions purely basing on sentiment. It is most efficient when added to a total trading strategy which incorporates both technical and fundamental analysis.
Misinterpreting Timeframes
The sentiment may change a lot in various periods. The sentiment in the short term could be bearish though the sentiment in the long term may be bullish. Always keep your sentiment analysis in line with your timeframe of trade.
Market Context Neglect
Among many other things, the market context involves consideration of laws and regulations, industrial practices, and the overall physical and mental well-being of the people. Essentially, you need to pay attention to what is going on in that market because it may well hold the key to your success in it.
Readings on extreme feelings do not periodically result to an immediate counter. In some instances extreme sentiment may be supported by powerful underlying reasons that lead to a longer-lasting extreme sentiment than is anticipated.
Constructing Your Sentiment Analysis Tool-Box
Begin with free data to use such as broker sentiment and COT reports. Once you have some experience, you can think about investing in high-quality sentiment analysis tools that combine data across several sources.
Scan your trades, the sentiment-based ones by themselves to ascertain their performance. You should use this data to narrow down your strategy and know which sentiment indicators suit your trading style most.
The Forex Future of Sentiment Analysis
Sentiment analysis is experiencing a revolution brought by artificial intelligence and machine learning. The same technologies allow concurrent processing of social media, news, and market data, more precisely and up-to-date sentiment readings.
Nonetheless the market movements are still driven by human psychology. Crowd psychology, coupled with the knowledge of emotional extremes, would always be very useful in the arsenal of successful forex traders.
Sentiment analysis is an art to learn over time and it is an important point which gives competitive advantage to one in reading the psychology of the market. Begin to apply these methods steadily, and keep in mind that sentiment analysis is useful when complemented by well-taken technical and fundamental analysis.
Reading the emotional temperature of the market puts you in a better position to make a better trading decision and possibly avoid the traps that swallow most forex traders.
