In financial markets, market sentiments play a major role in influencing the value of a financial asset. These opinions or sentiments sometimes catapult the price of a financial asset into unchartered territories. Whether you are using fundamental or technical analysis, market sentiment analysis is an unheralded branch of learning which dictates the direction of any financial asset. Hence, a detailed understanding of the subject will help traders stand in good stead in the long run.
What are Market Sentiments?
It refers to the overall attitude and perception of a trader towards a specific financial product or the market. In other words, the tone or the overwhelming feeling from the activities and the price movements of the securities trading in the market is called market sentiments. In general terms, increasing prices indicate bullish market sentiment while decreasing prices point to bearish market sentiment.
A common question in the financial markets will inevitably be: How do you feel about the financial markets, i.e., will it rise, fall or stay sideways? If you can decode the answer, then you already understand what is your observation of the financial markets, whether you are trading stock, forex, commodity or any other asset class. Markets are fuelled by emotions and this is one of the major reasons traders can identify opportunities to trade.
For example, one of the key reasons commodity prices do not necessarily match their real value is because traders are reading beyond the fundamentals of the commodity in question and pricing in their sentiment which can be influenced by a score of factors. This exemplifies the importance and impact of sentiments on the financial markets.
Decoding Market Sentiments
Market sentiments may not always represent the inference from the fundamental analysis. On one side, day traders and technical analysts count on market sentiments as they influence the various technical tools and indicators they use to measure and profit from the short-term price movements often influenced by the trader attitudes towards financial security. It is also an important tool for contrarian traders who like to trade in the opposite direction of the prevailing trend, i.e. going against the trend. For example, if a majority of traders are buying oil, a contrarian would sell.
Traders describe markets as bullish or bearish. When bears are in control, the asset prices are going down. When the bulls are in control, the prices go up. Emotion often drives the financial markets, so market sentiment is not always aligned with the fundamental value. Some traders profit by finding financial assets that are overvalued or undervalued based on market sentiments. The rule of thumb is to short the overvalued assets due to the overbought nature and long the undervalued assets due to the oversold nature. However, gauging market sentiments is tricky and will not yield 100% results. The outlook and the attitude of the market are shaped by anything and everything. Therefore, traders need to cast a wider net to ensure that they are gathering large volumes of information.
Trading Market Sentiments
Reading the corresponding volume of financial security is one way to evaluate market sentiments. This is true for any financial asset. If an asset price has continued to rise but the volumes are beginning to decrease, it could be a signal of an overbought scenario in the financial asset. In this context, it is important to wait for the right time to enter a short position and vice versa.
Market Sentiment Indicators
Market sentiment indicators are one of the most powerful tools at the disposal of the traders to gauge the market sentiments – to judge how the market feels now and where the sentiments are headed. This analysis will assist in finding the undervalued or overvalued opportunities. One of the most used indicators in the commodity markets is the Commitment of Traders (COT) Report.
Published by the Commodity Futures Trading Commission (CFTC) on a weekly basis every Friday, the COT report signals the net long and short positions of speculative and commercial traders. This helps outline the market dynamics by detailing how large traders (including hedge funds, banks and corporations) are positioned showing how committed they are to the current trends. If the COT report shows that major traders have shifted to more bearish sentiment in a seemingly bullish run, then this could point towards an upcoming turn in the corresponding financial security. In short, the COT report could be used as a proxy to gain an idea of the possible trend in the financial markets in the near future.
There are various ways to measure market sentiment and stay ahead of the curve before the breakthrough market reversals. Tracking sentiments should alone not be the be-all and the end-all of all market analysis but can be a useful addition to help add meaning and context to the analysis of a trader and comprehend where the markets are headed next.
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