In addition to trading support and resistance levels using various technical analysis methods , many traders also rely on some element of fundamental analysis.
Fundamental analysis is a set of analytical methods that usually focuses on the study of changes in underlying economic conditions as a catalyst that stimulates price movements.
Market sentiment is an important element for traders in their analytical review. It gives the trader an idea of whether the market will rise or fall, and also takes into account a number of important economic indicators that can affect the direction of the price.
Due to the psychological component that often dominates trading, market sentiment can have a significant impact on the future direction and volatility of trading instruments, as well as many significant geopolitical and economic events.
In addition, conducting a detailed and accurate market sentiment analysis can help a trader refine and align their own expectations with the market and provide a stronger basis for making profitable trades.
How can fundamental indicators influence market sentiment?
Most traders who use fundamental analysis will pay close attention to key economic data releases and the results of current geopolitical events.
The overall outcome of the collective decision-making process leads to the phenomenon of market sentiment. Market sentiment shows a psychological component that drives changes in the market value of trading instruments.
If economic and geopolitical factors for a particular country show a strengthening economy that should outperform other countries, this set of circumstances will tend to positively change underlying market sentiment for that currency and result in a better valuation against other currencies.
On the other hand, negative sentiment could emerge if less favorable economic data are released showing that the country's economy is slowing, or if a leading economic indicator such as consumer confidence begins to soften in response to less favorable economic data, such as a weaker market. labor.
For example, if a country is experiencing a growing gross domestic product, a narrowing trade deficit or surplus, attractive interest rates, or high employment figures, all of these factors should support favorable market sentiment for that currency.
What market sentiment indicators do traders use?
Market sentiment analysis can include a detailed analysis of data showing what percentage of transactions resulted in a particular position in a currency pair and what types of traders chose to take those positions.
For example, consider a situation where nine hundred high-volume traders went long the EUR/USD currency pair, while only one hundred micro-lot traders went short the opposite EUR/USD. In this case, a possible sentiment indicator might show an overall long position of 90 percent. Additionally, this sentiment data will show a 100 percent long position taken by high volume traders, who are generally considered to be more professional and therefore more likely to determine the future direction of the market.
For Forex traders, the most important and respected market sentiment data is the report from the US Futures Trading Commission (COT). Although this popular report on market sentiment refers exclusively to the futures market traded on the Chicago International Monetary Market, it is widely used because the vast majority of forex trading takes place on the unregulated OTC market. As a result, an accurate estimate of the volume of trades in any currency pair and the types of traders who make them up is usually quite difficult to obtain.
Despite the huge popularity of the OTC forex market, a number of traders also choose to use the Chicago IMM to trade currency futures contracts, which are available in most major currencies against the US dollar, as well as some minor currency pairs and crosses. The COT report shows the direction of the positions these futures traders have taken, as well as the size of those positions over a period of one week.
In addition to the COT report, some brokers publish useful market sentiment indicators on their websites or their own trading platforms that show what traders who trade with that broker are currently doing.
Another potentially useful form of sentiment indicator is the economic surveys conducted and published as indicators for the world's largest economies. Unexpected changes in the results of these polls can cause sharp market shifts in the exchange rate, and the crossover of key levels can be used as trading signals.
COT reports
The Commitment of Traders or COT report is one of the most useful market sentiment indicators available to traders.
It also provides information on other commodity and financial futures and derivatives markets in addition to currency futures and options.
The CFTC regularly publishes a report on the obligations of traders every Friday, unless Friday is a Federal Bank holiday. In this case, the release may be delayed by one or two business days. The information contained in the COT report is based on the futures and options positions that traders who traded through the Chicago IMM as of the previous Tuesday.
Although the release of COT data tends to be somewhat delayed, this information is still extremely useful for medium to long term traders. This information is used by many traders to plan their trades as an indicator of market sentiment.
The COT report lists several items that can be used by a trader to gauge investor sentiment and is one of the cornerstones of market sentiment analysis practiced by many currency traders.
The COT report is also divided into segments that show how traders position themselves in the futures market.
Open Interest is the total number of futures or options contracts that have not yet been offset by an opposing transaction such as delivery or exercise in the case of options.
Number of Traders - Shows the total number of traders who are required to report their positions to the CFTC.
Reportable Positions is the total number of futures and option positions held by traders that exceed specific reporting levels set by CFTC rules.
Non-Reportable Positions are the number of short and long positions that do not meet the reporting requirements set by the CFTC regarding their size.
Short Report - shows the level of open interest in each futures contract separately by the number of outstanding reportable and unregistered positions. This report shows additional data that includes the number of commercial and non-commercial transactions, any changes from the previous report, distribution activity, percentages of open interest by category, and the number of traders involved.
Long Report - This is an extended COT report that includes all the information contained in the short report mentioned above and includes both reportable and non-reportable items. The long report also groups data by year and shows the concentration of outstanding positions held by the largest traders.
Commercial (Commercial) - reflects the positions occupied by trading organizations that are interested in the production, processing and sale of a certain commodity, on which futures are traded on the Chicago IMM exchange. These positions are usually what is known as a "hedge" position for an underlying commercial interest position that naturally arises as a direct result of non-trading activities.
Non-Commercial - This classification includes the total volume of all speculative positions, which include positions held by individual traders, large institutions, hedge funds and other non-commercial users of the futures market that meet the CFTC reporting requirements. This represents a potentially useful index of speculative sentiment.
The COT report is one of the most useful forex sentiment analysis tools available to currency traders.
How to use the mood in the market?
The most common way traders tend to use forex sentiment is to measure extremes in market positioning and use that as a counter indicator. Essentially, when market sentiment levels reach extremes, the market in the prevailing direction is said to be overbought or oversold and therefore ready to reverse.
When the vast majority of traders are on one side of the market in a particular currency pair, more often than not the market will seek to reverse its prevailing direction or trend and the currency pair will correct.
As there are fewer and fewer traders willing to take the opposite side of a trade, it is often only a matter of time before a reversal occurs. Accordingly, extreme sentiment levels are usually seen as a possible signal for a market reversal.
However, one has to be careful here due to the predominance of long-term trends, which are often driven by changes in interest rate differentials.
It is important to remember that notable extremes can be reached for a particular currency pair, and yet the pair may continue to exhibit such extreme levels for an extended period of time.
In addition, macroeconomic and other fundamental factors may affect the national currency in such a way that market sentiment may give one signal, but due to exceptional circumstances, the market will not react as it is usually expected.
These news events may include a country's monetary policy, interest rates, a referendum on an important issue such as the Brexit vote, a geopolitical event, a natural disaster, central bank intervention in the foreign exchange market, or any other circumstance that could have a significant impact on the value of one or multiple currencies.
How does news affect price movement?
As you probably know, I prefer to ignore the news. Most of them are too boring and uninteresting. I am convinced that excessive obsession with the news can only confuse the market analysis and only ruin trading.
However, news can be extremely useful to you if you know how to use it correctly. In today's article, we will talk about assessing the mood of the market (the so-called market sentiment), as well as how you can determine the strength of buyers or sellers. Let's get straight to the point.
Before we get into the details, it's important to first understand how news affects financial markets.
Without news, the market would not be the way we know it. News constantly determines the bullish or bearish mood of market participants, which, in turn, creates volatility in the wave of buying or selling.
As price action traders , we should not be interested in understanding a news event. It is much more important for us to pay attention to how the market reacts to the release of this or that news. It is the assessment of market sentiment after a significant news event that helps us determine whether the market is bullish or bearish at a given time.
We know that the price does not always fall on bad news and rise on good news. Everything is far from clear.
Learning to Read Market Mood
The ability to read market sentiment is extremely important if you want to make consistent profits. This is nothing new for price action traders. The pin bars , inside bars , or outside bars we use are another method of assessing market sentiment.
However, I am going to show you another way to gauge the strength of the market through the news. I want to point out that we do not use the news itself to enter or exit a trade. This is not a trading strategy, but rather another tool for determining strength or weakness in the market.
So what exactly are we doing?
We just watch how the market reacts to important news. By big news, I mean any event that has three levels of volatility on any economic calendar.
Let's say that you are seeing an uptrend in your chosen trading instrument and are looking for buying opportunities. Or perhaps you are already long and want to increase your position by pyramiding .
Watching the reaction of a trading instrument after a news event, you can understand the mood of the market. Don't forget that we only need to pay attention to the most important news.
Below is a table that shows several different growth market scenarios and the sentiment associated with each:
| News | Price | Market sentiment |
|---|---|---|
| Positive | moving up | Bullish |
| Positive | Moves sideways | slightly bullish |
| Positive | Moves down | Strongly bearish |
| Neutral | Moves up | Bullish |
| Neutral | Moves sideways | Neutral |
| Neutral | Moves down | slightly bullish |
| Negative | Moves up | Strongly bullish |
| Negative | Moves sideways | slightly bullish |
| Negative | Moves down | slightly bearish |
As you can see from the table, if the news is negative or neutral, but the market continues to grow, this means that the mood in relation to the trading instrument is bullish. This is especially true if the news is negative but the price continues to move higher.
A continued trend in the market on negative or neutral news is a bullish signal. This is a sign that the buyers are in control and therefore the trend is likely to continue. The opposite is true for a falling market that continues to decline on positive or neutral news, which is a sign of weakness.
Here are some examples of how news results can be used to determine market sentiment:
In the first illustration, we see that the price is moving up on negative news. We are seeing an unexpected market reaction, and this can be used. If the price rises against the backdrop of negative news, this means that the general mood in relation to this trading instrument is extremely optimistic.
Now let's see how positive news can help us gauge the mood of a rising market:
When it comes to positive news in a rising market, we expect the price to rise.
On the other hand, if the market moves sideways after positive news, this will be considered slightly bearish. Buyers are not in a hurry to open long positions, so it would be best for us to refrain from opening long trades.
Finally, if positive news appears in a rising market and the trading instrument loses its value, this is a sign that the buying power has dried up and the bears are now in complete control of the situation.
Summing up
The ability to read the market sentiment after the release of important news events will significantly increase your chances of becoming a profitable trader.
Many traders who use technical analysis feel that they do not need to pay attention to the news. To some extent, it is. However, observing exactly how the market reacts to certain news events is the backbone of price action trading and should therefore not be ignored.
Remember that there is no need to analyze or even understand the results of a particular news event. It is important to observe the market reaction to certain events after the fact.
Here are a few things to keep in mind before you start learning to read market sentiment:
- News is a source of volatility in the market.
- As price action traders, we are not interested in understanding the outcome of a news event. It is much more interesting for us to trace how the market reacts to the news.
- You need to pay attention only to the most important news.
- The most revealing signal is an unexpected rise in the market on negative news and an unexpected drop on positive news.
- Using an estimate of market sentiment cannot be a trading strategy. Always use price action in conjunction with support and resistance levels to increase the odds in your favor.