Investing in the markets sometimes happens under the influence of emotions. This is why analysts of a given market might use words such as “fear”, “confidence”, or “optimism”. To understand the state of a market and the direction of a price, it is also necessary to analyze the sentiment that drives the trading of its participants. In this article, we will attempt to define the concept and shed light on its use in trading forex CFDs.
Investing and psychology: market sentiment
What does the term “market sentiment” or its synonym, “investor sentiment” mean?
It refers to the general mood of investors in a particular market. Market sentiment of course has an impact on the price of the relevant market. When price is rising, market sentiment is often said to be bullish. But, when the market price is falling, the market sentiment is said to be bearish. The term “market sentiment” refers to the prevailing emotion among investors in a given market: for example, fear or optimism.
Analysing market sentiment
Traders use various analysis tools to anticipate the direction of a price. Among those tools, sentiment analysis looks at general market conditions and sentiment amongst traders.
When trading Forex CFDs, sentiment indicators are intended to measure the market consensus, the share of traders who are bullish, neutral or bearish on a currency pair.
Sentiment indicators belong to contrarian analysis, itself belonging to technical analysis. The principle is to consider that the majority is always wrong and to take the opposite view. Contrarian investors will try to identify where the market is moving: is the crowd buying or selling a specific currency pair ? The goal will be to take a position in the opposite direction with the help of sentiment indicators.
How Sentiment Indicators Work
Sentiment indicators will show (usually in percentages) how many traders have bought or sold a given currency pair.
Sentiment indicators are very useful in situations where the percentage in one position reaches an extreme level.
For example: EURUSD continues to rise and 90 per cent of traders are long, which means that there are not many investors left to lift up the trend. This is when sentiment helps a trader identify a potential upcoming price reversal and the market might turn around.
How forex traders use sentiment analysis
When the investor crowd feels positive about a current economic situation, the environment is called risk-on, meaning an increased risk appetite. The opposite environment where investors have a negative outlook on the economy, is called risk-off.
This will in turn steer traders into trading specific currency pairs.
For example, the NZD/JPY pair has a tendency to drop in risk-off, and rise when the market is risk-on. Safe-haven currencies like the USD, JPY and AUD will strengthen in risk off environments.
However, sentiment analysis is not a replacement for other known trading strategies. It is a way to read the market and confirm your fundamental and technical analysis, or a starting point for a top-down approach where fundamental and/or technical analysis follow.
Sentiment indicators are available in the MT4 Accelerator pack, a useful add-on to your investment strategy on OneRoyal that will give you an even clearer image of market conditions.
Click here to take full advantage of OneRoyal trading tools and beef-up your trading strategy.
Disclaimer: This article is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration of your personal investment objectives, financial circumstances or needs.
