What is Forex market sentiment?

Forex sentiment explained

We will not exaggerate in case we claim that all FX traders in the global Forex community will always have an opinion concerning the Forex market. Additionally, everyone has a personal perception of why the FX market is moving in a particular way, and it's during trading that FX traders reveal this view in any trade they take. Frankly speaking, it doesn't really matter how convinced a Forex trader is that the markets will move in a certain direction. In addition, an irrelevant factor is how nicely trend lines line up, because eventually the trader may up losing. A Forex trader must understand that the Forex market is a synthesis of different views, ideas and opinions. The more market participants there are, the more individual elements mentioned above exist. All this forces us to claim that the combined feeling that market participants possess is what is known under the name of Forex market sentiment. In other words, it is the prevailing emotion or idea that the vast majority of the Forex market feels best explains the current direction of the FX market.

Sentiment analysis

The action of price should theoretically reflect all available information of the Forex market, although you should take into account that this is far beyond being a simple task for Forex traders. The Forex markets do not just reflect all of the information out there, because traders will instantly act in a similar way. At this point sentiment analysis comes into play. You may wonder what makes this type different from technical and fundamental analysis. Sentiment analysis is a kind of FX analysis that concentrates on indicating and consequently measuring the overall psychological and emotional state of all participants of the foreign exchange market. This kind of Forex analysis strives to quantify what percentage of FX market participants are bullish or bearish, in other words being optimistic or pessimistic. When the majority market sentiment Forex is successfully identified, a certain analyst will take up a position on the opposite side on the hypothesis that the crowd is mistaken. Trading only on sentiment is a contrarian technique depending heavily on bear and bull ratios and other sentiment indicators. Instead, sentiment analysis is frequently applied in synthesis with fundamental or technical analysis to add more depth to a trader's comprehension of the Forex market. You should be aware that utilising all three types of analysis simultaneously can be overwhelming, but worth the effort.

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Applying market sentiment to your advantage

Market sentiment is a relatively new calculation that polls market experts, analysts and strategists on their general feeling on the market. The purpose can be described as the following; the time you look at sentiment in the Forex market, you want to see what investors' thoughts are on the market. Undoubtedly one of the oldest sentiment surveys is the American Association of Individual Investors, also known as AAII Sentiment survey. The poll now is performed online and released every Thursday.

Certain businesses take into consideration trading data such as block trades or short interest, and also trends in stories published by financial news publications. There is also something known under the name of ten-day advance decline line for S&P 500. That is the metric which tabulates the number of stocks that were up versus the actual number of stocks that were down, and more than ten days the more negative the number, and consequently the more oversold it is in the Forex market.

There is an apparent paradox with the Forex sentiment. These polls or readings are just reflecting where the market has been and not where it is actually going. Most of the time this has lead to the survey forecasting that the market will go against the vast majority. That means, in turn, periods of high bullishness leading eventually to sell-offs and periods of downturn, as well as market bearishness signalling a market bottom. If everybody is bullish on the Forex market at the same time, then there are less people to persuade to get into the market, so that there is less future demand. Conversely, when most amount of people are bearish, they are going to become bullish in case market turns around. As a consequence, this is going to end up creating more demand for stocks.

Sentiment indicators

It would be a mistake to omit sentiment Forex indicators in this article. What is a sentiment indicator? This is a numeric or graphical indicator made to show how a certain group feels about market or business environment and perhaps about other factors. Sentiment indicators are aim to gauge the mood of the Forex market. You can find a lot of them on the internet. We would like to outline three indicators that you may find useful as an example:

  • Contrarian methods with sentiment indicators
  • Commitment of traders report
  • Volatility index (VIX)

We are going to briefly examine each one further.

Contrarian methods with sentiment indicators

Crowd behaviour is the basis of contrarian investing. That is to sell when optimism is at its peak, and purchasing when pessimism has peaked and the market has actually bottomed out. This approach exists only due to the fact that prices are defined by market sentiment. The behaviour of the crowd is a combination of a large amount of biased thoughts and processes, and thus it is virtually impossible to quantify. There are some tools, which are included in the category of sentiment indicators that we may use to define bullish or bearish sentiment. There are a lot of them and an unlimited number of ways to interpret them. Sentiment indicators should be combined with other indicators and with fundamental analysis as well. Moreover, FX sentiment indicators are transparent and most often freely accessible.

Commitment of traders report

The COT can provide up to date information about trends and the power of the commitment traders have towards this trend, by detailing the actual positioning of speculative and commercial traders in the diversity of future markets. You should bear in mind that the spot Forex is an over-the-counter market, so the future market is utilised here as a proxy for the concrete spot market. Additionally, the Commodity Futures Trading Commission (CFTC) publishes a new COT report each Friday. You may use it to get an idea of Forex market sentiment for the particular time period. The COT report in fact contains a lot of other useful information, however the essence of the report is data that shows the net long or short positions for every available futures contract for both commercial and non-commercial traders.

Volatility index or VIX

The VIX has a fair amount of popularity in the Forex trading community. This is generally because VIX is the sentiment indicator to measure an implied volatility. As you already know, volatility is the magnitude of move that a price diverges from the mean price over a set period of time. Furthermore, the VIX gauges the implied volatility rate rather than historical volatility of the options bought and accordingly sold on the S&P 500 Index. This is the peculiarity of this market sentiment Forex indicator. In case we regard options as a protective method against a corrective price movement against a major trend, then we undoubtedly understand the following. The bigger the implied volatility is, the stronger is the fear among the certain trend following traders that the Forex market is reaching an extreme.

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Conclusion

As you can see, Forex sentiment plays a huge role in Forex trading and investing. The mainstream mood on the foreign exchange market is an identifier of market directions. Adhere to what traders talk about, whether they are bullish or bearish. It actually helps in gauging the psychological and emotional attitude of all market participants. You can apply this analysis to predict market movements based on the current situation - this is where sentiment analysis differs from other two types. Furthermore, to make your analysis more precise and useful, you should use sentiment indicators. They can provide you with an insight into the underlying power of market movements. We advise you to look for extreme readings as a signal that prices are set to reverse. By understanding all mentioned above, you will understand what is market sentiment.

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