In this article we will explore sentiment trading in the Forex market. We will take a look at what sentiment is, what are some various types of sentiment, why it is important, various ways to trade sentiment, and some challenges that a typical trader may face when attempting to implement sentiment into their trading efforts.
What Is Sentiment In Forex Trading?
Sentiment, in its most basic form, is the “Mood” of the market right now. This is the mood of the market in the current trading session, in real time, as price action is unfolding in front of you. It’s similar to the macro fundamentals of the market except it lasts for much shorter periods of time.
One of the things that make sentiment trading interesting is that it has a finite life span. However, you can never really know with 100% certainty when it will change or end. Sentiment can last anywhere from a few seconds all the way to many weeks depending on how strong that particular sentiment is.
Sentiment can be both in line with the fundamentals but it can also move price in the opposite direction that the fundamentals economic trend would suggest. Really try and understand this point because it’s a very important aspect of sentiment trading. Sentiment doesn’t always have to be in line with the big macro picture. Later in this article we will explore how to trade sentiment.
Sentiment is what creates supply or demand for a currency. This is otherwise known as selling (supply) or buying (demand). The importance of this cannot be underestimated. Sentiment is so important to many day traders that they will spend most of their time trying to identify the current sentiment for their trading opportunities. If you are a day trader it’s definitely a good idea to be in tune with how the market is feeling during the day while you are trading.
For most institutional traders they want to keep the big picture fundamentals in the back of their mind but their biggest concern is typically on what the rest of the market is thinking right now. This helps them identify times when it’s right to jump into a trade, and hopefully make some pips in the current trading session.
The concept of sentiment is similar to underlying fundamentals. One of the most important things for traders at financial institutions is to identify the real reasons why the market is moving in a certain way. The underlying fundamentals tell them why something is moving a certain way over the medium to long term. The sentiment tells them why things are moving in the short term. Sentiment is the here and now.
All of this makes sentiment something that can be really important to understand for people that use a day trading or scalping trading methodology. No matter what or how you are trading one of your first goals should be to identify the prevailing sentiment in the market you are active in.
Sentiment Golden Rule
Sentiment is a form of fundamental analysis but for the short term rather than the longer term. The golden rule of sentiment is that the more something is known to the market the less of an impact it will generally have. This is something that you might want to keep in mind when trying to identify the sentiment and the expected market reaction caused by that sentiment.
Just like the moods of individual people, sentiment in the Forex market can change quickly and for a variety of reasons. Just think of the Forex market as a giant living person. Essentially, it is made of millions and millions of people all thinking, feeling, and reacting in the same time in their own unique way. The Forex market is simply an aggregate of all of those thoughts, feelings, and actions.
If you are a short term trader then understanding the current sentiment is a primary concern when analyzing the Forex market and trying to identify a trading opportunity on individual currency pairs. Your primary concern is going to be on the sentiment because any change in the sentiment environment can have a very large impact on any trades that you may have open at any specific time. It could also change in a way that presents you a new trading opportunity.
Fundamentals Versus Sentiment
Let’s first think of fundamentals as the big macro picture of the health of an economy. If the particular economy is performing well, people have jobs, economic data is strong, and interest rates are rising – then we would expect the currency of that nation to move higher over the long run.
People and financial companies want to invest in growing and stable economies that are performing well. In order to do that it means that they will need to buy the local currency of that economy in order to invest in it.
For example, if the United States of America is currently a booming economy then foreign investors will want to invest in the United States to make a strong return on investment. In order to do that they must first sell their native currency and buy the U.S. Dollar. If enough investors move their money into the United States then it can cause the value of the U.S. dollar to rise over time.
This is a perfect scenario example but we know that currency prices just don’t go up or down in a straight line forever. It would make the job of traders much easier if they did but that’s unfortunately not the reality.
Even though the big picture fundamental outlook may be overall positive there will be many days or even weeks when the price actually goes down against the long term fundamental trend. In these times this means that the “Sentiment of the day or trading session” has turned against the big picture fundamental trend. There are a variety of reasons that this happens but the key is that some piece of information forced price to be temporarily out of line with the big picture fundamentals.
Let’s now take a look at some of the more common types of sentiment that may move prices against the fundamental trend. Keep in mind that sentiment can be with the fundamental trend but it is more noticeable when it’s against it.
Types Of Sentiment
Now that we have looked at what sentiment is generally and how it differs from the big picture macro view of an economy, let’s now take a look at some of the more common things that may actually cause the Forex market to experience sentiment.
Risk on Risk off
What is Risk on Risk off?
When referring to the Forex market, risk-on risk-off describes a market environment where price fluctuations respond to, and are driven by, changes in risk appetite or tolerance that the majority of large investors have at this particular moment.
That is a pretty heavy definition so let’s try and break that down a bit further.
Risk-on-risk-off refers to changes in how money management firms and investors move their money in response to global economic conditions or geo-political events. During periods when risk is perceived to be low, risk-on risk-off theory states that investors tend to engage in higher-risk investments in order to gain higher returns. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments.
Lower risk return environments can also be perceived as a capital preservation environment. This is because investors will seek safety first rather than a gain on investment. They will do this for various reasons when they are concerned that their money might be at risk.
Historically speaking, the level of risk appetite markets will have tends to rise and fall over time as economic conditions shift from good to bad and from bad to good. This creates the 2 distinct moods of risk on and risk off that the market tends to have. Let’s take a deeper look into them individually now.
Risk on is an environment where the market is feeling like hunting for big profits. They do this because there is nothing to be worried about that will cause unnecessary risks in the market at the particular time. If there are no uncertainties or big concerns overhanging the market then the main job of asset managers and city traders is to make as strong of a return as possible for their clients and the companies they work for.
In these instances the market will look to trade the currencies that offer a higher interest rate yield or a potential higher price return on their money. Currencies that have a high interest yield attached to their particular economy do well because the purchaser of the currency gets to participate in that interest yield. Large asset management firms love a guaranteed interest rate and potential price appreciation from the speculation around these higher rates of return.
Currencies that tend to move a lot, and particularly those that have a higher interest rate attached to them, become the most attractive option for investors and traders in risk on environments. Emerging market currencies with decent economic prospects can benefit in risk on times as well. These will be the most common currencies to rally during a risk on session.
Stock markets of strong economies tend to do very well during risk on trading. This is because stocks are considered a bit more risky than something such as a U.S. Treasury and will therefore have a higher premium attached to them.
Because risk on is a sentiment it can last for as little as minutes to many weeks depending on how strong it is. It can also change instantly in response to the ever changing news and information flows that traders pay such close attention to. A major geo-political event, such as a war, can turn the best of risk on trading into a fast moving risk off environment instantly.
Risk off is just the opposite of risk on. This is when the market sees or perceives some sort of risk to its capital. This is a time where investors do not want to get involved with anything that is remotely perceived as risky for fear of losing money.
In times of risk off traders and investors become scared that the volatility will cause losses to their portfolios so they exit the trades that they think are the riskiest first. These riskier currencies tend to be the ones with high average daily ranges and with higher rates of interest. The idea is to get rid of anything that has a potential to cause higher than normal losses. Live to trade another day is the main thought process in a risk off environment.
During these times investors move their money into what are traditionally perceived to be safer currencies or assets. Generally, a safe currency is one that belongs to a country that has a current account surplus combined with a stable political and financial system with low debt to GDP ratios. This utopian ideology doesn’t mean that there is a perfect place like described. Virtually every country has high debt to GDP ratios. What the market is really looking for, without actually saying it, is the “least bad place” to put their money.
Basically, the market is looking for a nice safe place to park its money when there is a lot of fear. Which economy will be the last economy to collapse should the absolute worst case scenario materialize and the global financial system completely fall apart is the burning question on the markets mind.
When the markets flock to these safer currencies in risk off times it is known as a safe haven flow if there is a lot of fear dominating the overall market place. However, for more normal risk off environments, the market is just looking for a stable place to put money while the short term issue sorts themselves out so the market can get back to hunting for profits and creating a new risk on environment. As with all markets the Forex market is prone to the normal ebbs and flows of supply and demand.
U.S. Treasury bonds tend to benefit in risk off times because they are considered to be free of risk. If you have ever heard the term “Risk Free Rate” it is referring to U.S. treasury bonds because the market deems them to be free of risk. If the U.S. isn’t paying their debt obligations then the world has some very serious concerns to deal with.
Generally speaking, stock markets tend to sell off and assets such as gold tend to rise in risk off environments.
There is also a pit stop between risk on and risk off which is called a sideways market. This is a time when investors don’t know exactly which direction to move the Forex market or where to move their money.
A sideways market is dominated by the need for more information as traders and investors cannot come to a consensus on which way to trade the markets. Are we hunting for profits or are we preserving capital?
Essentially, the market is in a wait and see mode. Participants are looking for some kind of risk event, such as an announcement from a central bank or other high impact news, to give them the information they need so they can start buying or selling again.
Basically, the market is waiting for clues as to whether to go back into risk on or risk off. This is a market environment that can frustrate a lot of traders because breakouts go nowhere and price moves are less predictable and don’t move very far.
To make matters even more difficult, it is really difficult to call the end of a sideways market technically. There needs to be a wave of positive or negative sentiment that is strong enough to get the prices moving again in a sustained manner. Small events just won’t do the job in a sideways market.
Safe Haven Flows
We previously used the term “Safe Haven” while explaining risk on and risk off. Let’s now explore this term a little more and get a better understanding of what safe havens are and which currencies are actually considered to be safe haven currencies.
What is a Safe Haven?
Previously we learned about what a risk off environment is. Safe haven currencies and safe haven flows are very similar to that of a risk off environment. The major differences are the particular assets that move and the degree to which they move. A safe haven flow will tend to move much more than a risk off sentiment. It is still risk off, but it’s more like risk off plus some extra panic added to the mix. Sometimes this can be extreme panic.
A safe haven is any asset class or investment that the market would expect to hold its value, or potentially increase in value, when there is something that is causing a major fear or concern to filter through the markets.
The prices of safe haven assets will move a lot if there is a very real reason for something to cause fear or panic. A major geo-political event such as a war breaking out can quite easily cause safe haven flows as investors dump any risky investments and flock for safety. Prices can tend to extend much further than would seem rational because people and traders can get highly irrational at times.
Why Do Safe Havens Exist?
Safe havens exist simply because large financial and investment companies need a place to protect themselves in times of uncertainty.
Most of the time, for many financial companies, it’s not as simple to just move all their money into cash and step away from the uncertain times. In fact, most of the large asset management firms have a legal mandate to be close to fully invested at all times. This is because they have made that promise in writing to their clients in a document that is often referred to as a prospectus.
These companies are legally required to submit this prospectus to the regulators or monetary authorities that oversee their particular capital market. This means that they need to move from one asset class to another rather than straight into cash. And because so many companies are required to do this then they all tend to flock to the same sort of investments when there is fear in the market.
There is also a level of speculation to safe haven flows. If you think about it; if you knew that a particular asset class or currency tends to appreciate when the market gets scared then why wouldn’t you look to make a profit AND protect your money at the same time? This speculation can add even more fuel to a safe haven flow.
Safe Haven Currencies
Let’s now take a look at some actual haven currencies.
The Japanese Yen
At the time of this writing the Japanese Yen tends to get most of the safe haven flows in the currency market for shorter term flows.
This is an interesting safe haven currency because, while it does have a stable political system and the currency itself is very liquid and highly traded, its economic situation at current is not something that other nations are particularly jealous of.
Japan has struggled for decades to generate any significant economic growth and its debt to GDP ratio is off the charts being one of the highest in the entire world. Normally this out of control debt ratio would be enough to stop investors from placing any money into that economy. However, Japan is also one of the largest creditors in the world owning foreign assets that are comparable in value to the massive debt levels they have on the books. So this means that they can call in a lot of money when needed which is not something any other economy of Japan’s size can do.
Another interesting thing about the Japanese situation is that almost all of their own national debt is held internally by the people and businesses of Japan. This means that if the debt holders called in the debt to be repaid then they would effectively be pulling the ceiling down on their own house. It is highly unlikely that the people of Japan would knowingly collapse their own economy. Knowing this fact gives investors’ a lot of confidence in the Japanese Yen when there is something presently concerning the markets and there is a need for a safe place to park money in the shorter term.
Any fears of a collapse are highly unlikely even with their stratospheric debt ratios. All these reasons are why the Japanese Yen tends to be the first go to currency in times of safe haven flows and market panic.
If you are trading a Yen pair you should be very aware that if something happens in the news to cause fear and panic the Yen can and will react violently almost immediately as everyone plows their money into the Japanese Yen. This is especially true if you are shorting Yen at that time because you could be offside on your position quickly. It is not uncommon for the Yen to rally many times its normal average daily range in one session when there is a market panic brewing.
The Swiss Franc
This is an extremely attractive currency during times of turmoil because it’s backed by Switzerland which happens to have a very stable economy, a low debt to GDP ratio, and a long history of neutral and stable political system on the world stage.
The Swiss Franc can be so attractive at times that that the Swiss National Bank (SNB), the central bank of Switzerland, are known for constantly trying to intervene and weaken it in order to stop its high value from hurting its country’s exporting businesses. Switzerland is primarily an exporting economy so it doesn’t want to see the value of the Swiss Franc to get too high because this will cause lower profits and potentially deflation within the economy. Deflation is the kiss of death to any economy and central banks will do almost anything to avoid it even if that means deliberately weakening its own currency.
Because of an active central bank trying to deter investors, the Swiss Franc is usually only bought in large volumes during extremely worrying events that have the potential to last for the longer term. Think of war or massive financial crisis.
The one problem with the Swiss Franc as a safe haven currency is that the central bank takes an active role in deterring people from buying its currency. For years the SNB held a price floor with the EURCHF currency pair 1.2000 before they unexpectantly pulled it in January 2015. The Swiss national bank has no issue with manipulating the price of their currency at any time without warning to the market.
Another Interesting point, at the time of this writing the SNB actually have a negative rate of interest which means that investors have to pay to own Swiss Francs. This is again another way the Swiss National Bank is trying to keep the price of its currency low to help out its country’s exporting businesses. However, in times of mass panic investors have shown that they would pay a negative rate in order to keep their capital safe.
The U.S. Dollar
The USD has “historically” been one of the key safe haven currencies. This is because of its status as the world’s super power and also because it is the world reserve currency. It’s the world’s most liquid and widely used currency with a strong political system (most of the time) and typically leads the world during the good times with a robust economy.
The U.S. economy has a habit of bouncing back strongly from any large scale recession because they are a global leader in innovation and creative thinking. When there is a financial crisis the U.S. dollar becomes a primary safe haven currency because it is widely considered that the U.S. will not default on its debt. This makes the U.S. dollar valuable when investors are scared about the global economic situation and the prospects of other various countries over the longer term.
The one problem facing the U.S. dollar as a safe haven is its massive debt burden. This has the potential to cause the U.S. some financial problems if all of its debts were ever called in at the same time. Because of this the USD is generally the least attractive safe haven currency in the markets for shorter term safe haven flows. However, in major global recessions, such as the financial crisis of 2008-2009, the USD has shown that it will appreciate over longer term safe haven flows.
For shorter term immediate safe haven flows the market will buy up the Japanese Yen. For longer term fears and panics the market will look to buy the Swiss Franc and the U.S. Dollar.
Buy the Rumor Sell the Fact
Buy the rumor sell the fact is one of the more common types of sentiment that you may have heard about before. This is because it is so prevalent in the markets that it has become a cliché in the trading world.
So what does “buy the rumor sell the fact” mean and why should you be concerned about it while you trade the Forex market?
Buy the rumor sell the fact occurs when the market has a strong expectation of a certain outcome and then trades in line with that expectation before the particular risk event. A risk event is any piece of economic data or news that is scheduled to come out and is considered to have potentially high impact on prices of currencies in the Forex market.
How long the market will buy the rumor before the factual piece of data is released will all depend on how high impact the data is. The market will then trade with its expectations ahead of the expected event, and if it is what the market expected, the market will abandon the trade and the price action reverses as traders start taking profits from the nice profitable run up into the risk event.
Buy the rumor sell the fact example:
Imagine that the market is anticipating that the Bank of Canada (BOC), the central bank of Canada, will increase its main benchmark interest rate at its next rate decision announcement. Speculation started about 2 weeks before the rate statement and there have been various leaks to the press about the fact that the hike is going to happen. In fact, the bank of Canada themselves have come out with some strong wording that a hike is potentially coming soon.
What will happen in this type of scenario is that the price of the Canadian dollar will rally as speculators start piling into the Canadian dollar well ahead of the actual rate decision.
As the rate statement approaches the market has done a good job of fully pricing in the rate hike. When the actual event happens, and the BOC does indeed hike interest rates as expected, what you will likely see is instead of the market buying up Canadian dollars the market begins selling them off.
News traders get squeezed out of their long positions that they entered just after the announcement and end up losing money as the price goes opposite to what they thought it should or expect it to be doing based on everything they have learned about the Forex market. Higher interest rates are supposed to be positive for a currency.
So what happened in this example? The market had been so confident that the rate hike would happen that they started positioning themselves long before the interest rate hike had been confirmed by the Bank of Canada. When the time came for the hike the market was already in profit and decided to book those profits rather than risk getting into a new position.
When done in enough volume, this profit taking can actually move the price of a currency significantly. This is often seen at the end of large moves or at key support and resistance points in the trading session. As the rest of the market catches on to the fact that this has become a buy the rumor sell the fact type move they now start selling the Canadian Dollar to try and take advantage of this fact which of course pushes the currency even lower.
This can be a very frustrating for many traders because the price action goes the opposite way that it should based on the information that was just released. But what the trader fails to realize was the large move that took place for a couple weeks going into the risk event. This is buying the rumor and selling the fact. It defies logic at the time but when you go back to the past it makes a lot of sense. The market is a discounting mechanism after all.
Buy The Dip Value Traders
Value trading happens when value traders enter the market looking to position themselves in line with the long term fundamental trend. They look to do so when the shorter term sentiment has moved price in the opposite direction of the actual fundamental trend.
There will be many traders watching these developments to try and use the pullback as an opportunity to get back into the market at better price. Everybody loves a good discount! The only reason they can do this is because the sentiment has taken price to an attractive point where it makes sense to get back in the trade in the direction of the big picture fundamentals.
Buy the Dip Example:
Let’s say that a large financial institution is bullish on Great British Pounds and bearish on U.S. Dollars. In this case the institution would want to buy the GBPUSD pair because this would make them long the GBP and short the USD. But, the big question is when would they want to do this?
Value traders would want to buy the GBPUSD pair on some sort of pullback. Let’s say that Britain has one bad inflation reading a couple weeks back. This would cause the GBPUSD pair to drop in the short term. However, 1 bad piece of economic data in a long series of very strong data points does not change the overall trend; it merely will cause a short term pullback. When the price of GBPUSD gets to an attractive point on the pullback the value traders will sense a good bargain and buy the GBPUSD pair back up in hopes of making some nice profits. This is a great value trading situation because the fundamental trend is still intact but you now have a discount to get in at better prices.
Value traders can be classed as some of the largest hedge funds, banks, and financial investment houses in the world. Many funds are so large that they must become value traders because they need to have a longer term outlook. They need to have this longer term outlook because they have a huge amount of financial assets that are too large for shorter term trading.
These value traders look to get into a trade with the expectation of the fundamental trend resuming at some point. In some situations it could be that they are simply adding to an existing position at a more attractive price. A good bargain is hard to resist! When there is enough money behind this type of trading activity it effectively ends any type of short term sentiment against the fundamental trend that may have been in control up to that point.
The general rule of value trading is:
The further the short term sentiment has taken price away from the fundamental trend direction the more likely it is that value traders will look to get back into the market and hunt for a good bargain. Value traders will typically be on the hunt if price has moved significantly beyond the average daily range. They will be even more likely to hunt for a spot to get in if the pair has moved significantly over more than a single session. This can sometimes lead to sharp reversals back in the trend direction.
You identify this type of sentiment at times when you can see price has pulled back against the overall fundamental trend because of some short term sentiment that the market has over focussed on. It’s at these times when price has moved excessively that you can bet value traders are lurking in the shadows ready to pick up some inventory on the cheap.
Many of the largest funds in the world use value trading to one degree or another in their investment mandate so you know that they do definitely have the power to move the market if enough of these traders decide that something has value at its current prices.
Forex Option Contract Expiry
Every trading day we have many different types of option contracts expiring at many different times against many different currency pairs. But how do they move the price of the currencies? In simple terms, the option price can act like a magnet at times.
The contracts that we are referring to are “plain vanilla” options only. There are indeed many variations of how options are structured but for the sake of simplicity we will stick to plain vanilla options because they are the most widely used and tracked by the Forex market.
A plain vanilla option contract will be “live” and in play until expiry time which is set at 10:00 am New York time (15:00 GMT) each week day. We don’t actually see the details of whether it’s a “put” or “call” option unless you are dealing on the interbank market. What we are looking out for is the price action leading up to the 10:00 am expiry time.
If there is an expiry of a big option of, say 500 million or larger, then this will bring the markets attention to the price of the option. If the expiry price is close to where the market is currently trading, say 30 to 50 pips, then the price may be drawn to that option expiry level.
There are a few things that may happen when there is a large option expiry leading into 10:00 am EST:
The price may head towards the price level. This could be because the buyer of the option contracts wants to cash in on their bet. The only way they can do that is if they push price to the price level. If it is a big enough payoff then it makes sense to use some more money and push price to the level.
Price may reject strongly off the price level. This could be because the seller of the option contract does not want to payout the money so they defend the price level by pushing price away from that level.
When price gets to the level it may not move too far beyond it as the buyers and sellers fight it out.
Once 10:00 am comes to pass the options are no longer in play. This means that the battle between the winning and losing party is over and price is free to move without any intervention from either of those parties.
The impact of an option expiry will largely depend how big it is. However, if price is nowhere near the expiry level then the prevailing market sentiment will likely be the main driver of price action.
You can see these expiry levels posted in the news feed at Forex Live. Once you note where the large levels are you can mark them on your chart and spend a little bit of time watching how price reacts to help you learn how you might possibly take advantage of these events.
Prices can’t continue to go up or down in a straight line forever. At some point price is going to need to take a breather and retrace some of the previous move. It’s in these times, when nothing has happened to change the current sentiment, that the market may simply be taking some profits.
Traders love to ring the register and there is no better time than when the market has given them a nice extended move. As the market continues to move in one direction for a long enough period of time, more and more traders are going to start getting itchy fingers.
Profit Taking example:
Let’s say that there has been a nice 100 pip rally on the EURUSD currency pair because there was positive economic data out of Europe today. If the average daily range of the EURUSD pair is 80 pips then traders know that the move can’t continue on much further under normal circumstances. The more price rallies beyond the average daily range, the more likely it is that traders will start taking profits.
In order for the trader to take a profit they must sell what they already own. When enough traders start selling their long positions then this can cause the price to retrace. This is profit taking in its most basic form.
If price doesn’t retrace very much then this could mean that traders don’t really feel like taking their profits just yet; the reasons for being in the trade are still very strong. However, if you do get a profit taking retracement, and the sentiment has not changed from the original move, then this is a new buying opportunity to get back into the trade at better prices once traders finish taking profits.
Profit taking is interesting because it is a sentiment created from a previous sentiment. It is a sentiment created from the previous sentiment that moved prices far enough to create the need to take profits….which is also a sentiment!
Trading with Sentiment
Perfect Sentiment Trades
The very best sentiment trades happen when the current sentiment of the current trading session is in line with the big picture fundamentals. Said another way; the mood of the market today compliments the long term fundamental economic direction.
These are great trades because you have the power of the longer term investors who are using the fundamentals and the shorter term hedge fund traders using the sentiment to get into or out of their trades. Together they are all happily pushing the price in the same direction which can make for some great price action to take advantage of.
This is a time when you can make a lot of pips very quickly with trades that might not try to go against you very much if you have picked a good entry point.
The very best sentiment trades look like the following:
If the fundamentals are “positive” and sentiment of the day is “positive” then you can look to buy all day long at good buy points (however you define a good buy point). This is where you might want to use some well thought out technical analysis to time your entry.
If the fundamentals are “negative” and the sentiment of the day is “negative” then selling or going short all day long at good sell points is a smart idea. Again, technical analysis will help you time your entries.
These are the type of trades that tend to last longer and move more in terms of pips because most of the market participants are thinking of trading in the same way.
Counter-Sentiment Trading Opportunities
There is another situation where the sentiment and the fundamentals are actually opposite each other. These are counter-sentiment trading opportunities because they are kind of like saying counter trend to the fundamentals. But this doesn’t mean you can’t trade these situations.
Counter-sentiment trading opportunities look like the following:
If fundamentals are “Positive” and sentiment is “Negative” you have 2 options:
Allow the negative sentiment to bring price back to where it makes fundamental sense to start buying again in line with the big picture (think buy the dip value traders).
Trade the negative sentiment short against the positive fundamentals. This is where knowing how strong the sentiment is will help you make some profitable trades against the big picture fundamentals. These tend to be shorter term trades with higher risk.
If fundamentals are “Negative” and sentiment is “Positive” you have 2 options:
Allow the positive sentiment to bring price back up to where it makes fundamental sense to start selling/shorting again in line with the negative fundamental trend.
Trade the positive sentiment long against the negative fundamentals. This is where knowing how strong the sentiment is will help you make some profitable trades against the big picture fundamentals. These tend to be shorter term trades with higher risk.
The sentiment trades that are against the fundamentals tend to be the trickiest. These are the trades you might want to stay away from until you are comfortable that you have a high level of skill when it comes to trading and understanding the sentiment situation that is active in a live market.
Challenges with Sentiment Trading
There are no mechanical rules regarding how to trade sentiment. Unfortunately, it’s not black and white like technical analysis is. Trading sentiment is more of skill that is honed and perfected by spending time with the market and getting to know its moods and behaviours that it has when certain events that happen.
Sentiment can last for an hour, a day, or even months depending on what is causing it and how relevant the market believes the cause for the sentiment is to the current economic situation. It’s really all about what the market expectation of an event is that creates the initial sentiment. Once the news is out the market will then create a new sentiment based on what actually happened with news event.
An interesting thing about sentiment is that sometimes the market reaction to a certain event will be quite strong but then a few weeks later the exact same scenario will occur and the market will hardly produce the slightest move. The Forex market tends to become desensitized to information the more that it hears it. This can cause a lot of frustration for traders that are not staying properly tuned into what is currently driving prices in the Forex market.
A lot of what will cause things to change with sentiment is what the expectations from the market are. As we know, the market will always react more to information that is not known or is unexpected. Once the information is known to the markets then the price swings will become far less because the market has attempted to price in the information already. Old news is old news and the market continually wants to be given new information to drive prices.
Sometimes the market will be focussed on one thing but then something else happens and the original thing the market was focussed on is instantly forgotten. On other occasions the sentiment will last for weeks as the market becomes more and more obsessed with a certain piece of information as it continually tries to price that information in.
One way to try and understand the Forex market is to think of the market as a living breathing person because it will often display human emotions of fear, greed, and irrational behaviour.
Hopefully this article has done its job to provide you some useful information on what sentiment trading is and some of the way sentiment works in the Forex market. The other goal of this article was to peak your curiosity about a subject that may be new to you. We hope that you found some value that will help you improve your overall trading efforts.