What is Sentimental Analysis?
When doing sentimental analysis, traders attempt to
determine how market participants feel about a
particular financial asset or the overall market.
Beyond technical
analysis and fundamental
analysis, it is important to gauge whether a
market is bullish or bearish.
Why is Sentimental Analysis Important?
Market sentiment can significantly influence the
general direction of a financial instrument or the
overall market. The sentiment is the collective
consensus of market participants or the overall mood
of the market. The reason it is important to
determine market sentiment is so that you do not
have to trade against the overall flow of the market
or the collective consensus of other market
participants.
To understand how powerful sentimental
analysis is, consider that sometimes
markets move against the indication of major events
or news releases. For instance, the EURUSD
pair could be experiencing muted activity
ahead of a major news release such as the US
NFP. The news may come up better than
expected, which will imply a strengthening US
dollar. Logically, the EURUSD should drift lower,
but the market ends up edging higher. For the
average news
trader that did everything right, it would
be a surprise when everything goes wrong in the end.
But this is just one illustration of why it is
important to read and understand the market
sentiment, and not to trade against the collective
‘mood’ of the market.
How to Read Market Sentiment
In CFD markets
such as Forex,
establishing the prevailing sentiment reliably is
always a challenge. It is unlike other centralized
markets such as futures, equities, or bonds,
where definitive information can be gathered on net
long or net short positions. Nonetheless, there are
still tools that can help traders determine
prevailing sentiment in the forex market.
Sentiment Indicators
There is a wide variety of sentiment indicators
available for forex traders to utilize when
attempting to gauge the mood of market participants.
Some brokers usually display the order book or
buy/sell statistics of their traders. For instance,
when you are trading the EURUSD pair, you will be
able to see the percentage of traders who have
placed buy orders as well as those that have placed
sell orders. If 60% of traders have bought the asset
(and 40% sold), it can be deduced that the general
sentiment is favouring higher prices. In the case of
extremes (for instance where buy and sell orders are
90% and 10% respectively), traders may also consider
contrarian moves because there may be no more buyers
to support further advances. However, such broker
tools are only in-house, and the assumption that
they reflect the broader forex market may be
far-fetched.
Another popular sentiment indicator is the VIX.
Referred to as the ‘Fear
Index’, the Chicago Board of
Options Exchange Market Volatility Index (CBOE VIX)
measures 30-day expected
volatility based on options premiums paid in
the S&P
500 index. In the options market, premiums
represent risk; higher premiums imply higher risk
(thus a higher VIX reading), and lower premiums
imply lower risk (thus a lower VIX reading). The
indicator has values of 0 to 100. The VIX is not
calculated as a percentage, but its values are best
interpreted as such. For instance, if the VIX has a
reading of 30, it means that prices can range from
30% lower than the current levels to 30% higher than
the current levels. VIX traders typically watch the
20-level: a reading below 20 forecasts a healthy and
low volatile market; whereas a reading above 20
forecasts a higher risk trading environment.
Overall, the VIX measures the ‘worry level’ of options
traders. A higher reading implies that they
are getting nervous, whereas a lower level implies
that they are getting confident.
Commitment of Trader (COT Report)
The COT is a weekly report that shows aggregate
positions taken by different types of traders in the
US futures market. The COT is an important sentiment
analysis tool that is published every Friday by the
CFTC (Commodity Futures Trading
Commission). The report categorizes market
participants into three: commercial traders,
non-commercial traders, and retail traders.
Commercial traders are basically hedgers that want
to protect themselves against any unexpected price
movements in the market. That is, they are not in it
for profits.
The activity of commercial traders, on the other
hand, is most intense during potential peaks or
troughs in the market due to the objective of their
positions. Non-commercial traders are large
speculators that are in it for the money. They are
known as trend followers and will typically increase
their positions as the trends grow stronger and
stronger. Their activity only reduces when a market
has turned. Retail traders are small speculators who
mostly own less capitalized trading accounts. Their
trading patterns are erratic, but they generally follow
a trend when the market is about to turn.
The COT report is a great tool for analyzing the
underlying sentiment on any financial asset, and it
can help traders to trade in tandem with the market
‘mood’.
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