Education

How to trade market sentiment

Understand the mood of the market

Emotions
are the key to understanding financial markets. However, it’s tough to make
rational decisions based on them. Even if you think you read your emotions or
other peoples emotions, you may get lost in trying to comprehend the feelings
of the crowd. And the market sentiment is the emotions of millions of traders
around the world. If you’d like to know more about it, read the guide by
SimpleFX WebTrader.

The behavior of the
masses works differently from the mechanism that determines individual actions.
The discovery is quite old and well described in a book by a French
anthropologist Gustave Le Bon in 1895 “The Crowd: A Study of the Popular
Mind.” The author states some of the characteristics of the psychology of
the crowds: “impulsiveness, irritability, incapacity to reason, the
absence of judgment of the critical spirit, the exaggeration of sentiments, and
others…”

Trying
to take advantage form market sentiment is a common mistake by individual
traders, source:
SimpleFX WebTrader

Every trader knows the
importance of emotions. You can see it in market volatility; you can see that
some stock is overvalued in comparison to the company’s fundamentals, and
others are undervalued.

Just like people on a
rock concert, football game, or political demonstration transcend from
individuals to a crowd, traders around the world create an entity that has its
emotions and moods. The state of mind of the crowd of traders is called market
sentiment.

The market sentiment is
one of the three possible pillars for any trading strategy:

  1. Technical Analysis
  2. Fundamental Analysis / Trading
    the News
  3. Reading
    Market Sentiment

For Forex and especially
cryptocurrency traders fundamental analysis is much more difficult to apply
than on the stock market. That is why these markets traders focus on technical
analysis.

Bulls, bears and “dumb
money”

Understanding the
sentiment will let you know whether the crowd is optimistic (bull market),
cautious or pessimistic (bear market) about a currency, stock or crypto.
Identifying the current trend can help you predict the future overall market
sentiment and will open sentiment-based trading opportunities.

Market sentiment works
for all kind of markets, but it is very difficult to read. There are big
players, such as institutional banks that can play against the prevailing
sentiment, and seek for so-called “dumb money.” Wait until the crowd
gets all in on a particular position – be it long or short – and use the
trading power to incite a reversal.

Follow or go against the
market sentiment

There are two possible
strategies for using the market sentiment. You can go with the current and try
to join the crowd or trade against the sentiment. The first strategy would
include tactics involving the Fibonacci retracement tool, that can help traders
profit from local price corrections.

The second strategy is
all about hunting for reversals identifying support and resistance levels and
taking into consideration the overall market sentiment to decide whether a
breakout may happen.

Safe-havens play an
important role when the market sentiment goes to extremes, or there’s an
overwhelming uncertainty. Assets like gold, USD, CHF or JPY are considered an
excellent shelter in case of too much risk. When more volatile assets are
entering a bear market, traders (including the most prominent players) tend to
seek these safe-havens, which automatically creates a bull market on ultrasafe
assets.

The two most dominant
emotions

Fear and greed are the
most dominant emotions among traders. They are either afraid of losing money,
or they want to earn more. Greed is overwhelming at market peaks when the
bubble is created.

Bitcoin chart

A
classic example of greed taking over in the peak of 2017 Bitcoin bubble,
source:
SimpleFX WebTrader

More and more people
open the same long position on a hot asset be it a tech company, a currency of
a fast-growing economy or a popular cryptocurrency. Just take a look at the
most significant burst in crypto.

On the other hand, fear
takes over when the market hits bottom. Traders are panicking underestimating
the real value of an asset. A savvy investor can see an opportunity for opening
a long position in these situations. However, trading against the trend always
involves high risk.

How to identify fear or
greed? When you see a trend accelerating breaking new resistance levels without
any fundamental explanation – no critical information that would justify it –
you may expect the greed is in action. The same mechanism works the other way
around with fear. If during a downtrends support levels are broken without an
apparent reason, the fear may have taken over.

How to spot “dumb
money”

“Dumb money”
is where traders are taking the most popular and the most obvious moves.
Everyone takes the hottest position, more and more people join and put
themselves in a very vulnerable position.

Let’s take a look at
Forex, a market where individual traders compete with the largest banks to make
successful trades. Forex is as susceptible to market sentiment. Both the
biggest institutional traders and the smartest individual traders see where the
“dumb money” goes. Then when there’s the right time, the most
prominent players open an opposite position and take the profit.

You can find indicators
that show the number of traders having a short or a long position on an
instrument. It turns out that the market almost always suddenly goes the other
way rapidly cleaning the trading accounts of those who “hang out with the
popular kids,” that follows the crowd.

Hindsight bias

The market sentiment is
very easy to read if you take a look back. Everything seems to be visible. Even
if you are new to trading, you can easily spot greed taking over just when the
bubble is about to burst. However, at the time of the bubble, hardly anyone
notices it, even the wisest and most experienced traders.

It’s difficult to profit
directly from fear or greed taking over. Even if you can read the past and
present sentiment correctly, you need to know what the collective traders’ mood
will be like tomorrow. Without any insider knowledge or ability to influence
the prices with your trading volume it’s impossible to do it repetitively.

What is the best market
sentiment strategy?

Keep away from it. If
you don’t use the most popular technical analysis tools and don’t trade
reversals, you can avoid the riskiest moves. If you don’t want to play the
“dumb money” but avoid it, you can focus on developing an effective
trading strategy. You don’t have to know where the “dumb money” will
go. All you need to know is where the “dumb money” is usually and at
present.

There’s no good way to chase
sentiment. It doesn’t matter if you want to trade along with it or against it.
Guessing the future sentiment is a risky move, that’s why avoiding market
sentiment at all may prove to work best for you. Doing so you could develop a
sustainable trading strategy with the right mixture of technical and
fundamental analysis.

Don’t chase the
sentiment. Invest not in the most popular assets, such as EURUSD, but the ones
that are more off the radar. It’s best to find your own niche. Don’t be a herd
trader. Choose one of the hundreds of instruments available at SimpleFX WebTrader, and use the best technical analysis UX and tools to learn how to
trade effectively and don’t get disturbed.

This
article was submitted by SimpleFX
.

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