Market sentiment emerges as collective consequences of various factors, including fundamental and technical factors, chart patterns and important global news, among others.
In the forex market, price fluctuations often turn the market upside down in a seemingly erratic direction. This is due to market sentiment and the influence of economic fundamentals. However, what is market sentiment? What effect does it have on our trades? How to measure it?
There are several ways to measure it.
- Commitment of Traders (COT): Showing traders how different groups of people are trading in the U.S. futures market.
- CBOE Volatility Index: This represents the market's estimate of the expected market volatility over the next 30 days.
- Buy/sell ratio: The ratio of market participants' buy orders to sell orders.
How do those indicators help trader understand the market sentiment? What else should trader know about market sentiment?
What Is Market Sentiment?
Market Sentiment is an unofficial consensus on market assets and the macroeconomy among market participants (traders and investors). This unofficial consensus is an accumulation of various fundamental and technical factors, including price patterns and the release of economic data or global news that are considered important. These factors together form the general perception of the investment market community.
Every trader has their own opinion about the market, such as:
"Wow, market sentiment is so bullish after COVID vaccine introduction."
"Gold prices soar due to risk avoidance on North Korea conflict,"
and so on.
Opinions from all traders worldwide go together to create "market sentiment".
Each trader has their ideas on why prices go to a certain direction and where prices would go onward. Their opinions may differ from each other. Some of them may be right, while some others got it wrong. Because individual opinion only matters as a part of the general trend.
Important Terms Related to Market Sentiment
There are several popular jargons regarding market sentiment. The most common terms are "bullish" and "bearish" sentiment. Rising prices show that the market sentiment is bullish, while falling prices are bearish. But that is not all; here are four terms trader need to learn:
- Bullish Sentiment: Market participants are optimistic about an asset, buying and elevating the asset's price.
- Bearish Sentiment: Market participants are pessimistic about an asset and are busy selling it and pushing prices down.
- High Risk Aversion, Low Risk Appetite: There is an increase in risk in the market, so investors and traders are busy securing their funds in low-risk and safe-haven assets such as Gold, US Government Bonds, Japanese Yen, and Swiss Franc.
- High Risk Appetite, Low Risk Aversion: Uncertainty and risk in the market tend to decrease, so investors and traders dare to invest in higher-risk assets, such as stocks, emerging currencies, crude oil, and so on.
How to Measure Market Sentiment?
Basically, experienced traders and investors will be able to measure market sentiment using intuition. Certainly not a random insight, but derived from long experience and in-depth observation of market behavior. Users of Price Action analysis will observe market sentiment through changes in candlestick formations on historical charts.
There are several ways to measure market sentiment, including:
Commitment of Traders
The Commitment of Traders (COT) report is a document that comes out every week and tells trader how different groups of people are trading in the U.S. futures market. This report is put together by the CFTC in the U.S.
The COT report shows how many people buy futures contracts (agreements to buy or sell something in the future) and how many sell them. It also tells us how many people have what is called "spread" positions, which are a type of trading strategy.
Traders use this report to help them decide whether to buy or sell futures contracts. By looking at the report, they can understand what other traders are doing and whether they think the market will go up or down.
There are four main types of Commitment of Traders (COT) reports:
- Legacy COT Report: The traditional COT report shows futures and options positions in agricultural, energy, and metal markets. It distinguishes between commercial traders (typically producers or hedgers), non-commercial traders (often large speculators like hedge funds), and retail traders. It includes data on long, short, and spread positions.
- Supplemental COT Report: The Supplemental report includes additional details and classifications for retail traders. It provides information on the different types of non-commercial traders, such as managed money (hedge funds and other investment funds) and other reportable (traders not classified as commercial).
- Disaggregated COT Report: The report further breaks down the data for non-commercial traders, providing more detailed information about their trading activities. It distinguishes between different types of traders, including managed money, other reportable, and institutional traders.
- Traders in Financial Futures (TFF) Report: The TFF report focuses on financial futures markets, such as interest rates, currencies, and stock index futures. It provides data on the positions of different traders, including commercial hedgers, non-commercial traders, and non-reportable traders.
The most well-known volatility index is the CBOE Volatility Index, commonly known as the VIX. The VIX is calculated based on the prices of options on the S&P 500 index. It represents the market's estimate of the expected market volatility over the next 30 days. When the VIX is high, the market anticipates significant price swings or uncertainty, while a low VIX indicates expectations of stability or lower volatility.
A volatility index, often called a VIX, measures market volatility or the expectation of future price fluctuations in a particular financial market. It is often associated with stock market volatility, specifically the volatility of the S&P 500 index, but similar volatility indices exist for other markets.
Volatility indices are derived from option pricing models and are often used to gauge investor sentiment and market risk. They can help traders and investors assess market conditions and make informed decisions. Higher volatility levels may imply increased risk and the potential for larger price swings, while lower volatility levels may indicate a calmer and more predictable market environment.
This is how a VIX looks like
In forex trading, the buy/sell ratio refers to the ratio of market participants' buy orders to sell orders at a particular point in time. It provides insight into the sentiment and trading behavior of traders in the market.
The buy/sell ratio can be calculated by dividing the number of buy orders by the number of sell orders. For example, if there are 100 buy orders and 50 sell orders, the buy/sell ratio would be 2:1 or 2.
Traders and analysts often monitor the buy/sell ratio as an indicator of market sentiment. When the ratio is skewed towards buy orders, it suggests bullish sentiment, indicating that traders are more inclined to buy a particular currency pair. Conversely, a higher proportion of sell orders indicates bearish sentiment, signaling a preference for selling.
The buy/sell ratio can be derived from various sources, such as order flow data provided by brokers, trading platforms, or market sentiment indicators.
It is important to note that the buy/sell ratio is one factor to consider when making trading decisions. Traders typically analyze it alongside other technical and fundamental indicators to gain a more comprehensive view of market dynamics.
This is what a Buy/Sell ratio looks like. Traders can check the historical data for better information.
Why Should We Learn Market Sentiment?
As a trader, one of the trader's responsibilities is learning about market sentiment. Traders can't tell the market what they want, but traders can react to what's happening. Market sentiment is such a powerful driver that it can influence the direction and movement of the market.
Various media show that market sentiment is dominant in influencing the dynamics of market movements. Negative sentiment will weaken the price of an asset, while positive sentiment will strengthen price movements.
For example, if a dominant factor in the market forms a bearish sentiment, market participants must expect falling prices immediately, which prompts them to take appropriate action immediately. The definitive action can be profit-taking, hedging, or selling several assets.
On the other hand, investors' fast responses accelerate price movements. The downward trend can be sped up by the spread of information about this bearish news.
In short, market sentiment is an important part of the market itself. For an investor, market sentiment analysis includes understanding the emergence of sentiment, how it changes occasionally, and how to profit from existing and subsequent sentiment.
Sentiment emerges as collective consequence of various factors, including fundamental and technical factors, chart patterns, economic data releases, important global news, and market cycles. Thus, we have to study a lot of information on financial markets to learn it well.