UNDERSTANDING MARKET SENTIMENT: GUIDE FOR TRADERS

Retail traders will often hear about market sentiment in the media. But if you’re still in the learning stages with financial markets, this term might not be well understood. However, it can be useful to become familiar with market sentiment, because it implies gaining several important insights that eventually can turn out into effective ways to spot new trading opportunities across any type of assets, including currency pairs, stocks, indices, or commodities. 

For the time being, market participants are no longer focused on fundamentals, which puts technical and sentiment analysis into an important spot. In this article we’ll cover some of the factors any CFD trader should consider when conducting a proper market analysis.

To start with the basics, market sentiment is the aggregate perception of the participants involved in trading/exchange activities for any given instruments. It is bullish when prices are rising, bearish when losses occur, and choppy when there is no clear price directional bias. Other experts might have other metrics to measure it, including complex mathematical formulas, but as the term refers to, it has more to do with the psychology of the people involved. 

An accurate example is the current condition in the global stock markets. Most major indices staged significant returns since March 2020, which means the market sentiment is still bullish, but as many financial outlets are highlighting, investors are now tracking more “defensive sectors”, on the back of elevated inflation and ending fiscal support. 

That happens because prices can’t move up in a straight line for an extended period, leading the trend towards a maturing phase, when it is vulnerable to pullbacks on any negative headlines. 

A popular metric for market sentiment available on the web, designed by CNN Business, is the Fear and Greed Index, an indicator ranging between 0 and 100. If it is near 0, then the markets are dominated by fear, while if the figure is close to 100, then greed is motivating investors when making decisions. 

There are 7 indicators accounted for, including junk bond demand, put and call options, market momentum, market volatility, safe haven demand, stock price breadth, and stock price strength. However, although it is popular the fear and greed index is not always viewed as a reliable indicator by stock traders since it is sensitive to minor market pullbacks.

Analyzing the market sentiment is important for CFD traders mainly because it adds another layer when deciding which is the dominant market side in control of the order flow. Traders want to get involved when there is a major imbalance in price, which translates into volatility and price directional bias. 

Technical analysis remains a reliable tool, especially for short-term trading, but as traders add up new metrics like sentiment analysis, false signals can be reduced, mistakes avoided, and trading accuracy increased. 

At the same time, by simply analyzing the price action context, it is possible to understand how major market participants are investing/trading any liquid asset, without the need to spend resources on any proprietary tool available for sale on the web. 

On an in-depth analysis, understanding market sentiment and making new trading decisions based on that can have numerous implications for traders, 4 of the important ones being listed below:

• A clear picture of the market context – order placement and management are key for efficient trading, yet most traders skip some of the early steps. They should start with the market context because only that way they can see what is the dominant side in control and look for opportunities only in that direction. It is challenging to trade against the dominant trend since any pullback can be treated as an opportunity to rejoin the market by many other big traders. 
• An additional filter for decision-making – regulated brokers like easyMarkets encourage rules-based trading and a professional approach, especially now when uncertainty in the financial markets remains elevated, even though economic activity has gradually resumed to more normal levels. With sentiment analysis, traders will have an additional metric to gauge market conditions and take well-informed decisions. 
• Gaining an objective view -subjectivity is dangerous for traders, clouding their judgment when they need to take swift actions in the market. Trading is a skill-based endeavor and traders should avoid relying on their hunches. Instead, they can remain objective and place trades not based on subjective emotions, but rather on valid and measurable data. Sentiment analysis makes the trader focus on what others think about any financial instrument. 
• Expanding one’s knowledge on how markets function -any useful new information is one step forward for traders. If some are not yet familiarized with sentiment analysis, it could be a missing piece and one of the reasons why results fail to show up as expected. Trading is an activity requiring flexibility and consistent learning, the market sentiment being only one of the significant topics. 

If you’re a new trader, you’re probably eager to find out how they can determine the market sentiment on any asset or asset class. The pre-trading part of the day should involve analyzing how prices moved overnight. To gauge the market sentiment, traders need to see how investors are treating bonds, how is the volatility index performing, or other metrics like interest for high-yielding bonds, gold, or safe haven currencies like the Yen or Swiss Franc. 

The US dollar is still the global reserve currency and as a result, how it performs can have an impact on asset valuations globally. Traders interested in global markets should keep an eye on the dollar as well because it can be a leading indicator of how the sentiment evolved. 

On top of that, traders don’t only need to see what’s the sentiment at the moment, but also find out variables that might derail the trend in the near term. The recent release of the US job report or the European inflation figures are two fundamental factors that can make market participants change their view on the next direction moving forward. Economic releases like GDP, CPI, unemployment, or consumer sentiment are still monitored and lead to asset price volatility during the time of their release. 

For short-term traders, that equals numerous potential trading opportunities to exploit. Basic economic knowledge is required so they will know, once the figures are out, which assets and how will be impacted. Professional traders generally wait and see how the market digests the news, and only then look for trade setups.  

As with any other trading metric, the market sentiment has both upsides and downsides. Traders need to be aware that they don’t have access to enough data on how the big market participants are now getting involved in any asset. The sentiment thus remains an approximation and should not be taken for granted. 

At the same time, when using market sentiment to decide on whether to get in or out of a trade, flexibility is required, since this indicator can shift in a split second. Traders need to act fast and not get caught by fixed ideas. 

Ultimately, gauging the market sentiment is often done by reading articles on financial websites. That could provide useful insights, but also, more often than not these outlets will create narratives and try to find justifications for why assets performed in any given way. It could be misleading for traders, especially if a trend is during the transition phase and a move on the opposite side becomes more probable. 

In terms of the current market sentiment, it would be fair to assume that risk-taking is what investors and traders are all about. Major stock indices are trading near or at all-time highs, the USD has been pressured for the past few weeks on the back of diminishing prospects for a FED taper, and risks related to COVID-19 are not having any major impact on credit markets for now. 

Since fiscal and monetary support can be provided again if things get worse, market narratives like TINA (“There is no alternative”) and BTD (“Buy the dip”) are key when influencing investing behavior. Some market analysts are warning, however, that a deterioration in risk sentiment might occur until the end of 2021, given there hasn’t been any major setback for about a year.

Given all the aspects described today, analyzing the market sentiment can be an additional tool traders and investors can use to make better decisions. Challenging market conditions are demanding they use all the available data before allocating capital and by understanding sentiment swings, it is possible to get in and out of assets at the right moment, without sacrificing returns in the long run. 

Sentiment analysis can get done in many different ways, which leaves traders to conduct their own research and see what fits their regime better. Regardless of choice, if you’re a trader, your ability to understand markets in depth increases if technical and fundamental analysis is backed by sentiment analysis.