the concept of forex market sentiment explained

The Concept of Forex Market Sentiment Explained 

What if we told you there is a way for you to become a better day trader overnight? 

For some who have traded for many years without success, this would seem like an impossible task.  

However, the info we are about to share with you will show you a simple way of becoming a better trader from tomorrow. 

In this article, you will learn you how to evaluate the current sentiment of the market. 

Understanding why currency prices are moving can give you a profitable edge in your trading. 

Understanding Market Sentiment

So, what exactly is market sentiment? 

Wikipedia defines it as the “general prevailing attitude of investors”. In simple terms, it is the collective mood of all traders combined. 

Think of the market as a person with emotions just like you. It’s not some mechanical robot. 

It consists of thousands of human traders all thinking and feeling at the same time. 

According to IG, every trader is influenced by emotions like fear and greed. 

These emotions are visible in the way prices move. Emotions can drastically affect a trader’s mood and cause them to trade irrationally. 

We know our emotions can change in an instant. The market’s mood can also change rapidly. 

There are a variety of factors that can influence sentiment and we will look at a few of them later on. The market can switch from being frantically pessimistic to excessively optimistic. 

Investopedia explains that emotions can be costly. Especially for traders that are caught off guard by its sudden changes. 

Sentiment tells us the reasons why the price is moving in a certain way. Furthermore, it gives us the reasons why the market is buying or selling a specific currency. 

In short, sentiment can be understood as the current mood or feelings of the market. 

Why is knowing the mood of the market important?

The reason why it’s important to know the market’s mood is because of expectations. 

Knowing what traders expect in any given situation can give you an edge over the markets. 

Some of the biggest price moves occur when something unexpected happens. According to Babypips, we can expect volatile price moves when expectations are missed. 

Likewise, there are also the infamous “buy the rumour, sell the fact” responses. This occurs because of something happening that is widely expected by the market. 

Traders will buy the rumour ahead of the event and sell when the actual event takes place. 

Highly expected interest rate changes can have a “buy the rumour, sell the fact” response.  

Traders will buy a currency ahead of an anticipated hike and sell when the event takes place. 

This can also happen with the release of economic indicators. Let us suppose that the market is expecting a very strong GDP release for a specific country. 

A strong GDP number would normally be considered as a reason to buy a currency. 

However, the market might start buying the currency in anticipation of a strong GDP. Subsequently, when the data is released in line with expectations the currency is sold off. 

By the time most retail traders look to buy the large speculators are taking profit. 

 

The example above shows the impact that a “buy the rumour, sell the fact” reaction can have on the markets.  

The EURNOK price jumped (NOK value fell) even though the Norges Bank raised their interest rates. 

According to ING, in the above example, the accompanying statement was dovish. This led the market to sell the NOK despite an interest rate hike.

Not being aware of these types of expectations can cause lots of frustration.

Examples of how emotions can affect the markets

Not being aware of these types of expectations can cause lots of frustration. Sentiment is dynamic and can last anything from a few seconds to a few months.

Another reason why knowing sentiment is important is due to the impact of risk on the market. 

When traders are very positive about the global outlook they are keen to risk more. When they are negative about the global outlook they are more risk-averse. 

This sentiment relating to risk is known as risk-on and risk-off market sentiment. 

In a risk-on environment, we can expect higher-yielding assets to appreciate. This means things like Commodities, Equities and high yielding currencies going up. 

 

The example above is a classic risk-on tone in the market where equities are green across the board. 

According to Investopedia, traders change asset classes depending on risk sentiment. In a risk-off environment, high-risk assets depreciate as markets run to safe-haven assets. 

This means things like gold and safe haven currencies appreciate. 

All of this can have a massive impact on your trading performance and is vital to comprehend.  

Consequently, it’s important for traders to develop their skills and evaluate market sentiment. 

Things that can influence market sentiment

There are many things that can influence the mood of the market. For the purpose of this article, we will only focus on the most important ones. 

Later in the article, we’ll show you how to incorporate these things into your analysis. 

  1. Economic News Events

Why are economic news events one of the biggest influencers in the mood of the market?   

Markets.com explains it’s because these indicators demonstrate the health and direction of the economy. 

Central banks pay very close attention to the various economic data. Economic data helps central banks make monetary policy decisions. 

Therefore, traders closely watch important economic data. It paints a picture of an economy and helps the market anticipate future central bank policy. 

So how can you stay ahead of these economic data releases? The majority of them are scheduled in economic calendars.  

This means we know exactly when they are released and can plan ahead. For the majority of economic indicators, we can also see what the market’s forecasts are. 

There are great economic calendars available on the internet. Some of them are also completely free. 

Doing a quick online search for forex economic calendar should give a few options to choose from. 

  1. Central Bank Announcements

Why do central banks matter? Central banks oversee the monetary policy of a country. 

This means they are responsible for cutting and raising interest rates. Interest rates are one of the key drivers of currency prices. 

Consequently, any important announcements from Central Banks are closely watched by the market. 

Markets evaluate whether announcements offer clues to future interest rate paths and policy.  

For this reason, central bank statements and announcements can influence sentiment drastically. 

Below is an example of how sentiment surrounding a currency can change instantly. The EURUSD chart shows the massive sell-off after the ECB lowered their expected rate path. 

 

This demonstrates the effect that central bank announcements can have on sentiment. 

  1. Hawks versus Doves

Central banks normally consist of boards or committees. Each individual member within a central bank has differing opinions about monetary policy. 

The various members are normally classified as hawks, doves or neutral. 

Hawkish central bank members lean towards tighter monetary policy. In other words, they want to raise interest rates more aggressively. 

Dovish central bank members lean towards looser monetary policy. They want to keep interest rates lower for longer.  

Neutral central bank members are not biased either way. Consequently, they prefer to let the economic data convince them which stance is best. 

So, what do hawks, and doves have to do with sentiment? Well, the answer, once again, comes down to expectations. 

If a member of a central bank is considered hawkish the market expects them to want tighter monetary policy.  

So, if a hawk says something that is considered very dovish, markets can react quite strongly. 

In the same way, if a dovish member makes a very hawkish statement it can change the market’s mood rapidly. 

  1. Geopolitics

Another big influence on the mood of the market is geopolitics. 

What exactly are we referring to when we say geopolitics? The range of geopolitical factors that influence the markets are: 

  • General elections
  • Natural Disasters
  • War and military conflicts
  • Politics and Political instability
  • Sanctions
  • Trade frictions
  • Financial Crisis

If any of the above factors occur, it can really rattle the markets. This can happen in a positive or in a negative way. 

We know that markets are very emotional. For this reason, uncertainty is not something traders handle very well. 

When geopolitical factors cause uncertainty the mood normally shifts to risk-off sentiment. What makes it even worse is that most geopolitical developments are not planned. 

They happen when nobody expects them. This can exacerbate the reaction of the market. 

The UK Brexit referendum in 2016 is a good example of how geopolitics can influence currency prices. 

 

The above GBPUSD chart shows the massive depreciation in the British Pound after the vote. 

This was an extreme example of geopolitical factors. However, it shows why it is important to stay on top of such developments. 

Step by step process for analysing current market sentiment

So how do we put all this information together to build a picture of current sentiment? 

Below is a step by step process you can follow to analyse the market’s mood. The implementation of this process will become easier with practice. 

  1. Find out what moved the markets yesterday

Your first step is to find out what events moved currency prices yesterday. 

Knowing what moved the markets yesterday will give you a great recap about what to focus on in the upcoming sessions.  

However, not all events will have a sustained impact on the price. 

Sometimes the market moved due to a massive beat or miss on an economic indicator the previous day.  

That data point might not be important enough to continue moving the market the next day as well. 

Therefore, your research will be important to see whether traders are still paying attention to it. 

  1. Find out what happened during the start of the current trading session

Did something happen that moved the markets at the start of your current trading session? 

Was this something that traders were expecting to happen? Remember the four main influencers we talked about above. 

If there were economic data releases how did they compare to the expectations? How did the market react to it? 

Is there anything that happened which can cause sustained movements in the price? This is where a great understanding of the Fundamentals come into play. 

A good knowledge of Fundamental Analysis will be a crucial tool you will need. Fundamental skills will help you evaluate whether moves are sustainable or not. 

  1. Find out what is happening later today that can potentially move the markets

What economic data is coming out during the current trading session? More importantly, what is the market’s expectations for those data points? 

It is important that you find out whether there are expectations for data releases to move the markets. These are the type of data points you need to focus on with your research. 

Furthermore, get into a habit of reading research articles from investment banks. There is plenty of free week-ahead articles that discuss upcoming data points. 

Make sure to read up and research the data points so that you tune into what the market is looking for. This will give you an edge knowing how to trade in the case of big surprises. 

  1. Evaluate whether the current sentiment is enough to move price in favour of your trades

Knowing when big moves in the price will be sustainable takes some experience and practice. 

Make sure to evaluate the potential sustainability of the market’s mood before trading. Ask yourself whether the sentiment will drive price in your direction. 

If you are not sure whether the market’s sentiment supports your trade it is best to avoid trading.  

  1. How does the current market sentiment align with the longer-term Fundamentals?

It’s important to differentiate between short-term sentiment and long-term Fundamentals. 

Longer term Fundamentals are the big picture view of an economy and monetary policy. This is the longer-term view of the future value of a currency compared to others. 

The bigger picture Fundamentals can be completely opposite to current market sentiment. 

Some of the best trading opportunities occur when sentiment aligns with the Fundamentals.  

When the current sentiment differs from the big picture Fundamentals you should be more cautious. 

Where can you find the information that you need?

There are plenty of resources on the internet that you can tap into daily for market info. 

Various investment banks offer great research articles. Moreover, these articles range from current events to upcoming market developments. 

There are also research platforms that offer in-depth market research and insights. 

There are also news feeds and news squawks. News feeds provide minute by minute updates of important market developments. 

A news squawk works like a news feed. It also has the added function of audibly calling out market-moving news.  

This is extremely valuable and allows traders to jump in and out of trades quickly. 

Finally, there are economic calendars. 

Economic indicator calendars are a quintessential tool in forex trading. In other words, it’s something that you should never trade without. 

The free economic calendars available on the market are also useful.  

A key feature of the subscription calendars is that economic data have no lag. It is normally released exactly on time. 

As a result, traders can jump into the market a lot quicker to take advantage of fast moves.

Summary

In this article, we learned why it is important for traders to be able to evaluate market sentiment. 

We also saw some examples of the main influencers that can affect sentiment.  We also learned a simple step by step process for evaluating the mood of the market. 

Knowing what the market’s mood is can help traders stay out of bad trades and stay in good ones. 

As a first step, you need to get tuned into the news. Start by watching economic news releases and observe how prices move afterwards. 

Secondly, find market research from reputable investment banks. Read up on how their analysts view the market and interpret past events. 

Thirdly, bookmark a forex news feed and follow events and how they unfold on the charts. 

It will take some practice and experience to get into the habit of evaluating the mood of the market.  

However, if applied correctly it is something that can improve your trading overnight. 

Please leave your comments or questions in the comments section below. We try and base our content on the feedback we receive.

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