When talking about analysing financial markets, technical analysis is usually most favoured, followed by fundamental analysis. After these 2, the third type of analysis used is usually sentimental analysis.
To quickly recap, we say that Fundamental analysis focuses on news, economic indicators and governmental policies (such as increasing or decreasing the interest rates).
Technical analysis is broader but mainly focuses on the charts and a trader’s behaviour. Since behavioural trends tend to repeat themselves technical traders hope to benefit from the patterns on the chart moving in a similar fashion to what they did before at similar pricing levels.
Now recapped, below we will focus on sentiment analysis.
What is Sentiment Analysis?
In a nutshell, this concerns the market sentiment. How traders feel about the current market state. Optimistic (bullish, expecting the market to go higher) or pessimistic (bearish, expecting the market to slump).
As markets are normally moved by the flow of volume within a particular direction, you will find traders that rely solely on this type of analysis. Usually, those are long term traders (or investors with larger account balances) and more experienced ones. It’s certainly not recommended for day trading (even though many retail traders try to do it).
Combining Different Types of Analysis
Some, on the other hand, prefer to combine multiple of all three types of analysis before pulling the trigger (and from our point of view – it’s the smartest thing to do).
If you stop and think about it for a second you will see that fundamental and sentiment analysis are closely related, especially in unexpected situations.
Brexit referendum was such an unusual event. The fundamentals (United Kingdom’s vote was to leave the European Union) were the reason why the sentiment switched from Bullish (in the previous year) to Bearish. Some traders love to think about it this way – fundamental analysis is giving us the reason, while the sentiment is the final push of momentum.
However, this is not set in stone – there are situations where the market (the participants or the traders) will be a step ahead. The anticipation for a given event might lead to increase in prices before the event takes place.
You will find numerous trading strategies based on Sentiment Analysis. Majority of them focus on the intermediate to longer-term trading and very few will be short term or even scalping strategies (scalping refers to very short term trading – opening a closing trades in a matter of minutes or hours).
Below is the so-called “Community Outlook”. It shows a detailed view of each instrument.
Let’s break it down:
Symbol Popularity – shows what percentage of all traders are currently trading the specific instrument. Why is this important? If there aren’t enough people trading the asset you are interested in, the sample is too small, and therefore the statistics you will be relying on, are not that reliable. Here is an example.
Only 2% of the traders are involved in GBPCAD. Which means I wouldn’t rely on the numbers below. Try to stick with assets that have at least 30% involvement from the community.
Here are the readings for EUR/USD.
In this case we see that 80% of the traders are already short (bearish, they have already sold) while only 20% of the traders are still bullish. We can also see the corresponding lots (Volume column) as well as the Positions at the end.
How to use the Sentiment Indicators in your trading?
Looking for reversals
One of the strategies involves looking for extreme points in the percentages. For example, anytime the percentage is above 90% or below 10% you start looking for signals in that direction. Usually what happens is that the majority of retail traders will start jumping in before the actual reversal happens.
Let’s use the example data from EURUSD above. Currently, 80% of the traders are already bearish. That means once we see the number reaching 90% (or whatever number your research will tell you to use) you can start looking for sell signals.
Below is an example of a USDJPY chart on a 4 hour time frame. The bearish pressure is building up (based on the sentiment indicator). We will wait to see extreme numbers on the sentiment, like 90% or so, verifying that the early traders are already selling, and then we’ll wait for technical confirmation. What we will do is simply wait to see some bearish evidence, like break below the rising trend line, or creating lower lows on the chart.
And if it will develop as we expect and the momentum goes towards the downside, we will be in the green.
Another way to trade is against the crowd (but not in extremes). It is in our nature (the retail traders nature) to look for bargains, in other words, to try and call peaks\tops and lows\bottoms on the market.
When we see a large trend developing, our instincts kick in and tell us to look for the opposite signal because anything that goes up must go down at some point (That’s the logic of the average retail trader). Statistics don’t agree though. As mentioned above, until the extreme points are reached, chances are the price will continue in the opposite direction of what the trader’s sentiment is. Retail traders tend to enter their trades much earlier then the professional traders do.
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