The importance of understanding sentiment in trading

The importance of understanding sentiment in trading

What is sentiment in trading?

Sentiment refers to the mood of traders related to a specific market. As traders develop a certain sentiment towards the market, it affects their positioning and in turn, the price action as it unfolds in real-time.

 

A specific sentiment does not go on forever. In fact, sentiment may shift within minutes but could go on for weeks on certain occasions. If you’re wondering where a specific sentiment comes from then it’s worth analyzing the behavior of human beings in relation to Mood swings.

 

Sentiment can be in line with what the fundamental analysis of an asset or market is saying but on some occasions, sentiment can be headed in the opposite direction and that could create sudden pullbacks and corrections in the market, against the main trend.

 

Understanding sentiment is an important aspect of a trader’s journey, especially for short-term speculators. For the most part, this is what drives the market. In a way, sentiment reflects the reasons why a specific market is moving in the short run while fundamentals tell the story over a longer period of time.

Important rule

It’s important to remember that the more something is familiar and known to the markets, the less impact it will have on price action. In other words, It’s good to focus on sentiment and pinpoint potential shifts that could become trading opportunities. After a while, the sentiment may begin to fade if not seen at its early stages.

Fundamental analysis versus Sentiment

As previously mentioned, Fundamental analysis focuses on the bigger picture and one that extends for a while. Sentiment highlights the current feelings of traders towards the market and whether they believe the trend should resume or a correction is necessary. This turns into a battle of supply and demand which will determine where the market will go.

 

Let’s assume that Europe is witnessing an economic boom where investments are flocking and the entire region is growing with good economic data day after day. Suddenly, everyone wants to invest in Europe and in order to do so, would need to exchange their currency to Euros in order to access the local markets there. While this sounds like a perfect scenario, such events would trigger massive demand for the Euro which could drive prices higher.

 

The above is focused on the fundamental picture of the asset while the short-term sentiment views could vary from one day to another depending on how traders feel about the product. For example, after an extended uptrend, traders may begin to notice exhaustion signs and a shift in sentiment given recent weak data. Such a sequence of events could mean a correction is underway and maybe even trend shifts on higher time frames if it persists long enough.

Types of Sentiment

There are three types of sentiment: Risk on, Risk off, and Sideways Markets. Risk on refers to a riskier appetite where people develop a short-term and higher tolerance to the existence of risk while Risk-off will see people more risk-averse and cautious with assets or products that are usually volatile and risky to trade and hold. Sideways markets denote neutral conditions where uncertainty exists but not enough to warrant a rush towards safety-linked assets.

 

Risk On

When market players are feeling confident and looking for bigger profits, the sentiment is referred to as Risk on. This corresponds with a lack of uncertainties and no serious concerns that are expected at the time which pushes traders and investors to go for more volatile assets and products that could offer greater returns than usual.

 

For example, if market conditions are supportive of bigger gains, traders may seek currencies with a higher yield if interest rate differentials are present. Furthermore, traders may look to buy higher volatility stocks (Figure 1) such as tech companies as well as trade indices that benefit from calm and smooth market conditions. They may look to dump holdings in Gold and bonds as those are traditionally linked to Risk-off sentiment.

Figure 1 – Daily Nvidia chart implying possible positive sentiment

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Risk-Off

This is the opposite of Risk on and highlights an environment that could see uncertainty and elevated risk. Risk-Off will see traders preferring to move away from volatility and may exit positions or use products to protect current holdings.

 

Traders may focus on the currencies of countries that have historically been seen as safety linked such as the Japanese Yen (Figure 2) and the Swiss Franc. Furthermore, traders may focus on buying government bonds from countries that have stable economies as well as invest in Gold and other precious assets that have historically seen gains during uncertain times.

 

During Risk off, traders are looking for safe places to park their money and while many products have historically proven themselves to be either risky or safety-linked, other financial instruments may suddenly earn new qualities as economies change.

Figure 2 – Daily USDJPY chart showing Yen strength

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Sideways markets

In this case, traders are seeking more information across a neutral market where some risk and uncertainty exist but traders are not too concerned and do not see a volatile and bleak outcome. In other words, market players are simply waiting for the next hint that could push the market out of its sideways and ranging conditions..

 

It is very hard to predict when a market may move out of sideways conditions but major news that could be upcoming or expected in hours, days, or weeks could be a trigger to see certain instruments move out of their current range. Nonetheless, the events would need to be bigger in nature, especially if the sideways conditions have been going on for a while. To explain this further, sideways conditions usually precede major news so one can expect an important event once the market enters into ranging conditions.

Safe haven flows

Safe haven flows refer to money leaving riskier assets towards assets or markets that have historically enjoyed stability and safety.

 

Safe haven flows are similar to Risk Off sentiment but could add extra panic and concern to the current sentiment which forces a broader exodus of funds towards those specific assets or markets.

 

Major geopolitical events such as defaults or wars could see this taking place and massive flows will take place, reshaping and redefining current trends or establishing new ones.

 

As mentioned before, safe haven markets products include the Japanese Yen, the Swiss Franc, the US Dollar, Gold, and government bonds.

Japanese Yen

Despite a very high debt to GDP ratio, Japan is one of the largest creditors in the world which means, money could be called in case of economic difficulties across the country. Furthermore, and aside from the fact that the Japanese economy has enjoyed stability for years, most of the debt is held internally by the people and businesses.

 

The Japanese Yen is one of the top currencies that people invest in during uncertain times and conditions. It can be quite volatile if a certain event suddenly takes place as people rush to it.

Swiss Franc

Another major currency backed by a country with low debt, a highly stable economy, and a history of neutrality when it comes to conflicts and politics. In fact, the Swiss Franc can be so attractive to the point that the Central Bank will purposely intervene by selling the currency to weaken it, a move that supports its export-oriented economic model. All of this serves to avoid deflation which could really put a burden on a strong and stable economy.

Figure 3 – Daily US Dollar Index chart showing volatility around the start of the Covid Pandemic

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Aside from the active role that the Central Bank takes, the Swiss Franc has a negative interest rate, meaning traders will pay interest when buying the Franc, another approach used by the government to support a lower rate given how often traders flock to it for safety-linked reasons.

US Dollar

As one of the top superpowers and the world reserve currency, the US Dollar (Figure 3) has long enjoyed the status of being the go-to currency during times of turmoil or uncertainty. It’s the most liquid and widely used currency in the world, backed by a strong political system, and is seen as a leader when the entire world is economically growing.

 

Despite occasional setbacks and recessions, the USA tends to bounce back given the attractiveness of the lower prices on some of the most widely traded and most popular instruments available across their markets. The US is one of the least likely countries to default on debt and this has made it quite an attractive location for traders to park their money in.

Buy the rumor, sell the news

This is a common approach taken by many traders in the market. When the market is expecting a certain outcome from a specific event and the odds are relatively high for that to happen, as soon as the event takes place, traders will position themselves in line with that event ahead of it and as soon as the release comes out, they will reverse their positions.

 

In this situation, many traders are already positioned and aware of the event and at the moment of release, new traders come in, betting that more of the original direction will manifest itself. The new traders will be squeezed out as the older traders are already in profit and ready to close their positions which will help reverse a specific product or market. Once this happens, everyone will be on the other side, pushing against the original current.

 

To many traders, this is very frustrating but it’s worth paying attention to powerful trends before major events as they could simply reverse when the release is out.

Value Traders

This is common practice across the markets where people might believe an asset is destined for higher prices but in the short run, a bad economic release causes it to dip. In this case, many will find the price attractive and in line with the main trade so they will rush to initiate buy positions. In other words, such trades present bargains for those who are looking to position with the main trend.

 

This is prevalent in the world of stocks to the point that value traders come in after a major recession, seeing signs that a specific economy will bounce back despite how negative it is at the moment.

Profit Taking

After holding profitable positions, traders may start considering closing them to realize the gains. This is normal and happens after sharp moves in the markets for those who are positioned correctly. Profit-taking dictates corrections and how high or low they go. mild and shallow corrections indicate minor take profit by the masses while deeper ones could mean a shift in sentiment over the short run.

 

Profit-taking takes place after minor moves but is more significant when the market has been trending for a while. This is where contrarian traders will start betting on a reversal by analyzing and expecting when those profitable traders will start exiting their positions.

How to trade with sentiment

The easiest and most obvious way to trade with sentiment is when it aligns with the overall fundamental picture of an asset or market. Let’s say the fundamentals are positive while sentiment is also positive. In this case, everything aligns and traders will look for a technical setup to get the very best entry that will help them benefit from the upcoming move.

 

It might be easier said than done but it's important for anyone trading with sentiment or just trading in general to first analyze the main trend before deciding what the sentiment is. Sentiment is only good for trading on its own when it's clearly defined and would last long enough for traders to benefit from.

 

There are some challenges when trading sentiment including how long it may last after defining it. This is a problem as the situation could quickly shift from a pullback of the sentiment to a complete reversal of the sentiment which could catch people off guard.

 

In this case, traders should always be wary of how deep the pullbacks are and make sure, once again, of the main trend in place as that is the direction that any investor or trader should be focused on.

 

The sentiment is another important tool to use and one that can be defined in a variety of ways. Always look for how price is reacting in relation to upcoming major events. Are people buying the rumor and potentially looking to sell the news? How healthy is the main trend? Are the fundamentals in line with the current sentiment? Are technicals overextended which could indicate an upcoming bout of profit-taking?

 

All those questions are important as they help you take advantage of such tools and eventually establish a nice system and procedure for scanning and analyzing trades.

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