It is well documented that investor’s psychology impacts how the currency exchange rates fluctuate. And sentiment analysis can be the key to understand why price moves the way it does. Everyone may have an opinion on where the market should go, but ultimately, the market price is determined by how traders are positioned in the market.
This brings us to a key element that can explain irrational behavior of the market which is market sentiment.
What is Market Sentiment?
Whenever you open a trade you are making a financial commitment. And in doing so, you are expressing your view on what you feel the market should do. The overall market sentiment is derived from all of these opinions, trades, and ideas of all market participants. This combined market position is what we can define as market sentiment.
Traders can tap into this comprehensive view of the market as a way fo doing analysis. There are technical indicators that offer retail traders a view of all the orders and positions currently open with the broker.
Tools for Sentiment Analysis
There are technical tools that can help you gauge the market sentiment. The typical sentiment indicator will show the percentage of traders for long versus short.
This is a short summary of all open positions by retail traders at Oanda. It shows that 87% of the client orders on XAG/USD (Silver to United States Dollar) are long. This means that 87% of the participants placing orders think that the price of Silver will rise against the Dollar.
This is a short summary of the sentiment of major currencies at eToro. On the second row, it shows that 80% of the open orders on GBP/USD are selling because they believe the value of GBP will rise against the Dollar in the short term.
Contrarian Trading Using Sentiment Analysis
The sentiment analysis can help you spot contrarian trading opportunities. A contrarian trading strategy trades against the current market trend. Contrarian traders are looking for points where a trend is likely to reverse.
Contrarian trading is far from risk-free. When you’re trading against a particularly strong trend, the market can sometimes continue to trade in the same direction longer than you can stay solvent. This is why it’s important only to trade those particular instances when you have extremely good information to support your conclusion on future market movements.
It’s recommended to only trade those instances when the market sentiment reaches extreme levels of more than 70%. In this case, you may consider fading the market or trading against the trend.
Contrarian Trading & Sentiment Analysis Example
From the first OANDA sentiment analysis chart above, we can see that EUR/AUD satisfies this condition of almost 75% of retail traders being short on this market. The next step is to look for significant support and resistance levels to time the market. The sentiment analysis tool only gives you the state of the current market, which is why you need to use this sentiment analysis in combination with other supportive technical analysis tools.
Successful contrarian traders try to minimize their losses and maximize their profits. There are two key steps that can help you achieve this:
- First, use a protective stop loss to ensure any losses are well contained
- Secondly, identify a strategy that allows your profits to run in order to benefit from the superior trading opportunities that the sentiment analysis method can provide you.
Incorporating sentiment analysis into your own trading can add a competitive edge to your strategy. It can help you quickly identify new trading opportunities that few others are aware of.
Smart traders wait for sentiment to reach extremes. A large number of traders wait for significant and strong data before engaging the market. Once all the trade setup conditions are made, be patient and wait for the market to confirm your analysis before entering.
The main idea behind sentiment analysis is that you don’t have to know the exact probability of a trade. All you need to know is if sentiment will be better or worse in the future, and base your trades on that conclusion.