Sentiment analysis is used to gauge how other traders feel about a particular currency pair.
Earlier, we said that price action should theoretically reflect all available market information. Unfortunately for us forex traders, it isn’t that simple.
The forex markets do not simply reflect all of the information out there because traders will all just act the same way. Of course, that isn’t how things work.
This is why sentiment analysis is important. Each trader has his or her own opinion of why the market is acting the way it does and whether to trade in the same direction of the market or against it.
The market is just like Facebook – it’s a complex network made up of individuals who want to spam our news feeds.
Kidding aside, the market basically represents what all traders – you, Warren Buffet, or Celine from the donut shop – feel about the market.
Each trader’s thoughts and opinions, which are expressed through whatever position they take, helps form the overall sentiment of the market regardless of what information is out there.
The problem is that as retail traders, no matter how strongly you feel about a certain trade, you can’t move the forex markets in your favor.
Even if you truly believe that the dollar is going to go up, but everyone else is bearish on it, there’s nothing much you can do about it (unless you’re one of the GSs – George Soros or Goldman Sachs!).
As a trader, you have to take all this into consideration. You need to perform sentiment analysis.
It’s up to you to gauge how the market is feeling, whether it is bullish or bearish.
Then you have to decide how you want to incorporate your perception of market sentiment into your trading strategy.
If you choose to simply ignore market sentiment, that’s your choice. But hey, we’re telling you now, it’s your loss!
Sentiment analysis is often used as a contrarian indicator.
There are a couple ideas why this is.
One idea behind this is if EVERYONE (or almost everyone) shares the SAME sentiment, then it’s time to go hipster and trade against the popular sentiment.
For example, if everyone and their mamas are bullish EUR/USD, then it might be time to go short.
Why? Unfortunately, you’ll have to go further down the School to find out! Ha!
Another idea is that most retail forex traders (unfortunately) suck. Depending on where you find statistics, between 70-80% of retail traders lose money.
So if you know that these all these unprofitable traders who are usually wrong are all currently long EUR/USD….well, theeeeeen.
It might be a good idea to do the opposite of what they do!
Being able to gauge market sentiment aka sentiment analysis can be an important tool in your toolbox.
Later on in school, we’ll teach you how to analyze market sentiment and use it to your advantage, like Jedi mind tricks.