What is Forex Market Sentiment and How to Trade it?

In addition to technical analysis and fundamental analysis, market sentiment analysis is also an important tool to help traders confirm the current trend. This is a type of forex market analysis that focuses on gauging the general psychological and emotional state of investors in the FX market. In this article, we will outline what market sentiment is, how it relates to forex trading, and what the top sentiment indicators are.

What Is Market Sentiment?

While all forex traders bring their own strategies, preferences, and emotions to the trading market, the collective trends behind those sentiments can reveal a lot about how overall trader sentiments may shape price movements and forex market activity.

Generally speaking, when the majority of traders have similar thoughts and behavior patterns in a given period of time, the balance of the bull and the bear will be biased to one side, and an upward or downward trend will naturally develop under the impetus of the market forces.

Market sentiment is all about collecting the thoughts and behaviors of investors in the market. For example, if market participants are sure that the market will be growing, they start buying actively and thus support the bullish trend. On the contrary, if most players are sure that the price will be falling, and a bearish trend will appear – they will start selling assets that they expect to decline soon. As a result, market supply will become excessive, making the price drop.

As such, traders use sentiment analysis to define a market as bullish or bearish, with a bear market characterized by assets going down, and a bull market by prices going up. Traders can gauge market sentiment by using a range of tools such as sentiment indicators, and by simply watching the movement of the markets, using the resulting information to make their decisions.

What Factors Influence Forex Market Sentiment?

Market sentiment is mostly influenced by so-called fundamental factors. They include various financial, economic, and political events that influence directly currency rates. Such factors are studied by fundamental analysis.

1. Economic Events

This is by far the most important and the most influential part of the fundamental analysis, and it takes one thing to master it: the economic calendar. The information in the economic calendar is released by central banks, reserve banks, and private companies to show the performance of the economy, which may in turn influence the value of an economy's currency.

2. Political and Geopolitical Events

Another important part consists of political and geopolitical events that surround a currency pair, including wars, elections, power changes and natural disasters.

3. Seasonality

The seasonality is related to some seasonal factors that aren't related to weather like "January Effect", a perceived seasonal increase in equities prices during the month of January.

The influence of fundamental factors on Forex market sentiment can be short-term or long-term. For example, information about the growth of unemployment last month can have a short-term negative effect on market sentiment, while an announcement of the CB head about the necessity to increase interest rates can form a long-term positive sentiment to a currency.

Technical Indicators to Identify Market Sentiment

Sentiment Forex indicator refers to a numeric or graphical indicator that displays how a particular group of market participants feels about the market or a business environment or some other factors. There's a lot of information available online on popular market sentiment indicators.

1. The Commitment of Traders Report

The Commitment of Traders Report, or COT report for short, is a weekly sentiment report that can provide forex traders with important information on the positioning of currency pairs. It is made by the US Commodity Futures Trading Commission (CFTC) and released every Friday at 15:30 east coast time.

The report covers covers all assets, but forex traders are interested in the currencies section. All large traders who move the market are required to report their positions regularly. These major market drivers include institutional traders, hedge funds, big banks, and more. And the weight these traders pull on the markets can sometimes be staggering enough to drive trends. As retail forex traders, the best bet is to trade like big financial institutions.

2. Volatility Index

The VIX is a volatility indicator that is widely followed by traders in the equities, futures and options market. Unlike most other traditional indicators, the VIX is a very unique technical study. It can help us understand the overall sentiment within the market, and the amount of fear or complacency that traders and investors are feeling at any given time.

In markets, volatility represents confidence or fear. When the VIX approaches 0, it reflects a sentiment of investor confidence. When the VIX moves towards 100, it reflects pessimism or fear on the part of these same investors.

3. Moving Averages

Another popular and demonstrative instrument for assessing the sentiment is the Moving Averages. They show the average value of the chosen currency pair in a certain period. If the price rises above the average, this means the current sentiment is positive; if it drops below the average, the sentiment is negative.

To assess short-term sentiment, use the MA with a short period, for long-term sentiments – the MA with a larger period. For example, when the price crosses the 200-days SMA from below, this means the sentiment is becoming positive, and an uptrend might be starting. And vice versa, if the quotations drop below the 200-days SMA, this means negative sentiment and promises a downtrend.

Conclusion

In conclusion, Forex sentiment is an essential part of Forex trading and investing. The sentiment or the prevailing mood in the Forex market serves as an indicator of the current market direction. Complying with what investors talk about, be it optimistic or pessimistic helps in identifying the psychological and emotional attitude of all market participants.

Forex sentiment indicators come in several forms and from many sources. Using multiple sentiment indicators in conjunction with fundamental and technical analysis provides a broad view of how traders are manoeuvring in the market.