Understanding Market Sentiment: A Guide to Trading Psychology

Have you heard of “market sentiment” in trading lingo? Think of the market like a big party where everyone has their own thoughts on where a currency’s price is headed. Well, market sentiment is basically the overall mood of all those partygoers.

But what does this term really mean? Put simply, market sentiment is what most people in the market think will happen to a currency’s price. It’s like a shared mindset that influences traders’ decisions.

For instance, if most folks are buying a currency, others might want to buy too. And when most are selling, the same goes. This collective behavior is what market sentiment indicators in Forex reveal.

So, how does this indicator look? Well, on platforms like Admirals, you’ll find a visual or numerical representation of the overall sentiment about the currency market.

These indicators are handy because they help figure out if most traders are feeling optimistic or pessimistic about a currency. But how do you use this info to your advantage?

Some folks use market sentiment to do the opposite of the crowd. For example, if everyone’s buying, you might consider selling. This is based on the idea that the majority could be wrong.

But remember, trading based on market sentiment isn’t foolproof. It’s a risky technique that works better when combined with other types of analysis, like technical or fundamental.

It’s crucial to understand that trading always involves risks, and there are no guarantees. To avoid common mistakes, it’s essential to educate yourself well and not rely solely on sentiment indicators. Combining different types of analysis can be more reliable and help you make more informed decisions in the Forex market.

How to Make the Most of Market Sentiment in Your Trading

Market sentiment is a relatively new technique that takes into account the opinions of experts, analysts, and strategists about currencies. The purpose of market sentiment is to analyze investors’ thoughts.

One of the oldest surveys regarding this is the AAII sentiment survey, which is currently conducted online and publishes results every Thursday.

Other companies consider information like stock lots, short positions, and financial news trends.

There’s also a factor known as the 10-day advance/decline line for the S&P 500. This line adds up the advancing values and subtracts the declining values, then adds the index value of the previous 10 days. The lower the number, the more oversold the Forex market is.

This seems to be a paradox in market sentiment. Surveys are just a reflection of past market positions, but they don’t indicate future movements.

Usually, the results of these surveys reflect that prices will move against the majority positions. This can indicate bullish periods leading to recessions and bearish periods signaling that the market hits bottom.

If everyone in the market assumes bullish positions at the same time, then there will be fewer people entering trades, which in turn reduces future demand.

Similarly, when several traders take bearish positions, they will have to switch to bullish positions later if the market goes in the opposite direction, thus creating more demand.

Best Market Sentiment Indicator

It would be a mistake to overlook market sentiment indicators. What is a market sentiment indicator?

It refers to graphical or numerical indicators that point out the opinions of a certain group about the market, trading environment, or other elements. There are several sentiment indicators online, all aimed at measuring the mood of the Forex market.

Here, we’ll discuss 5 stock market sentiment indicators that can be useful:

  • Contrarian Opinion Theory with Sentiment Indicators
  • Commitment of Traders (COT)
  • Report Volatility Index (VIX)
  • Breadth Indicators
  • On-Balance Volume Indicator (OBV)

Let’s dive into each of them in detail.

Contrarian Opinion Theory

Collective thinking is the foundation of contrarian opinion theory. This concept involves:

Selling when optimism is at its peak Buying when pessimism hits rock bottom and the market bottoms out. This technique is based on the idea that market sentiment defines prices. Crowd behavior is a mix of thoughts and biased processes, making it impossible to quantify.

However, there are some tools known as market sentiment indicators that can determine whether the market is bullish or bearish. There are many indicators of this kind and almost infinite ways to interpret them.

Commitment of Traders (COT) Report

The COT report gathers traders’ positions in the futures market, providing insights into trends. Keep in mind that the spot Forex market is OTC (over the counter), so the futures market is just a representation.

Published every Friday by the CFTC, the COT report gives an idea of Forex market sentiment. It contains a lot of useful information, but what really matters are the total long and short positions of futures contracts by professional and retail traders.

The VIX Index Measures Market Sentiment

The VIX is quite popular among traders as it measures implied volatility. Volatility, as you may know, is the magnitude of price divergence relative to its average over a given period.

The VIX measures the implied volatility of financial options (rather than historical) based on purchases and sales in the S&P 500 index. This is the uniqueness of the VIX indicator regarding Forex market sentiment.

To understand this indicator, consider that financial options are used as a hedge against trend changes in Forex. The higher the implied volatility, the stronger the fear that a particular trend is coming to an end.

It’s considered normal when the VIX is between 20 and 30. Whenever it’s below 20, it means the market is calm, hence there’s no volatility. Currently, it’s slightly above 30 (as of April 16, 2020), but days ago, it reached 80 points, showing market panic due to the coronavirus crisis.

Market Sentiment – Breadth Indicators

Forex market breadth is based on the number of currency pairs involved in the trend. Greater breadth validates the direction of a trend (whether bullish or bearish). Among the most popular breadth indicators are the new highs/new lows ratio and the advance/decline ratio.

To calculate the advance/decline indicator, take the stocks with a higher closing price than the previous day’s and divide by the stocks with a lower closing price over the same period.

On the other hand, the new highs/new lows ratio is the ratio of stocks reaching the highest point in 52 weeks divided by the number of stocks reaching the lowest point in 52 weeks.

When breadth indicators move in the same direction as the Forex market, it’s a trend confirmation signal. Conversely, a divergence between these indicators and the market suggests the trend may be changing.

Bullish divergences occur when the Forex market bottoms out and the number of declining stocks or new lows increases while their respective index continues to fall. Bearish divergences occur in the opposite situation, where the number of rising stocks or new highs decreases.

You can learn more trading concepts and how prices behave on charts through our free online courses.

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