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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