When it comes to trading forex, you are likely to have decided to include some technical analysis tools as part of your strategy. These help you to identify trends and patterns in the markets, and make informed trading decisions based on probabilities. They allow you to pinpoint the optimum entry and exit points, maximising your chances of making a profit.

Chances are, you have also learnt about fundamental analysis, and apply some of your knowledge when making trading decisions. This keeps you in the bigger picture about the factors which might influence the markets, to help identify opportunities and mitigate against loss.

However, a third analysis tool which is sometimes overlooked is sentiment analysis. Here’s a look at what sentiment analysis means in the forex market, and how you can use it to strengthen your trading strategy.

As the name suggests, sentiment analysis involves reading the ‘mood’ of the other traders in the market, and deciding whether the overriding sentiment is optimistic, or pessimistic. This might seem irrelevant when you can use hard facts such as economic data releases and price action charts, but it is more important than it might first appear.

The overall direction of emotion can have an influence on how the markets will move. Sometimes, this can be in direct opposition to your own thoughts and opinions, but you as an individual are not able to have any influence on the wider market sentiment. Therefore, regardless of your own hunches, you need to learn how to gauge the mood of the market.

You can then choose to go against the current direction, if you personally think that the market will move differently, or you can go along with it. The goal is to identify when a current trend is about to peak, so that you can take advantage of the swing point and maximise your gains, or avoid undue losses. 

Bullish and bearish markets

Before getting into more detail about sentiment analysis, it’s important to understand what bullish and bearish markets are. Both these terms reflect the mood of the majority of forex traders at any one point in time, and how optimistic they are about whether the market will rise or fall.

The terms ‘bull’ and ‘bear’ refer to the way these animals attack their enemies: bulls strike their horns upwards, so a bullish market means one where prices are expected to rise, and investors are buying.

Bears, on the other hand, attack with their claws, swiping downwards. Therefore, when prices are expected to fall and investors are selling, it is called a bearish market.

Because forex trading involves both buying and selling currencies, both market conditions can provide opportunities for traders, to either sell currencies at a profit when they are at their peak value, or to buy undervalued currencies in order to sell at a profit later.

The important thing is to recognise the characteristics which shape each type of movement, because the direction can change quickly and sharply. By learning to understand what makes it tick, you will have a much better chance or staying ahead of the curve.

You will then be able to watch out for the signs of change closely, and incorporate the market sentiment into your trading strategy. This will help you to manage risk better, and determine the most advantageous entry and exit points into the market.

What factors cause a bullish or bearish market?

Several factors influence whether a market is bullish or bearish. These can be economic, political, geopolitical, or technical. If you have already studied fundamental analysis, you will probably have a good idea of what type of events and data releases to look out for.

One of the most consistent pieces of data to follow is the interest rate, particularly at the moment when the central banks of most of the world’s major economies are making regular adjustments. Currently, interest rates are rising to try and control the inflation rate, which is also rising.

Markets normally move ahead of anticipated interest rate rises, so it’s important to follow the economic news. On the other hand, the markets often overreact to unexpected news, so it’s important not to follow the herd, and get caught up in turbulence.

At the moment, the world economic and political picture is especially complex. As the world’s economy continues to bounce back from the effects of the pandemic, employment rates are high. However, ongoing issues with supply chains, caused by backlogs which built up during lockdown periods, are still hampering recovery in some sectors.

Russia’s invasion of Ukraine has complicated the picture still further, sending energy and fuel prices soaring, and driving up the cost of basic foods such as bread and cooking oil. This in turn has led to sharply rising levels of inflation, which in most countries are not keeping up with the pace of wage growth, even though unemployment is generally low.

Differences between trading conditions in bull and bearish markets

Trading a bull or bear market isn’t simply about reversing your procedures, and the markets don’t act in direct opposition to the previous direction of movement. Bull markets tend to build up gradually, over months or even years. A current upward trend of a few weeks should not be interpreted as a bull market.

On the hand, bear markets can happen abruptly. Therefore, you should be ultra vigilant for any headwinds of change in a bull market, and be prepared to act fast. This means short selling, unless you are prepared to sit out the downturn over months or even years.

How to use sentiment indictors

Forex traders use tools called sentiment indicators to help them assess current market conditions. These can give an indication have how the majority of traders are behaving at any one particular time and date. This data can be expressed as percentage points to make it quick and easy to comprehend.

This data should be used as a part of your overall trading strategy, rather than a direct prompt to action. Here are some of the main methods used by forex traders.

Commitment of Traders Reports

Futures traders regularly check the Commitment of Traders (COT) reports, which are released every week by the Commodity Futures Trading Commission (CFTC). This is also a useful tool for forex traders to become familiar with, because it provides detailed information about the demand for currencies and commodities.

It can take some time to understand how to read the COT data, but in general you should bear in mind that the larger speculators and leveraged money and asset managers with trade in line with current trends, where as commercial traders follow counter trends, in order to hedge.

When the market is overloaded with speculators, it tends to go into reversal. On the other hand, when there are fewer large speculators, it tends to lead to an upturn in the markets. When speculators are crossing over from short to long term positions, it tends to mean that conditions are set to remain consistent for the time being.

The terms of trade of the country you hold currencies for is also important. For example, if you are currently heavily invested in the Canadian dollar, you should monitor the demand for Canada’s major exports. These include oil, natural gas, agricultural produce, and timber. When world demand is high, such as at the moment, the value of the currency will rise.

What is risk sentiment?

A part of market sentiment is the attitude of investors and traders to risk. When the mood is risk-averse, which tends to happen during periods of recession, currencies which are regarded as a ‘safe-haven’, such as the US dollar and the Japanese Yen, tend to rise in value.

When confidence is high, during periods of consistent economic growth and high levels of employment, the market becomes more risk-tolerant. This means that traders are willing to take on higher risks in order to maximise their returns, and invest more in minors and emerging markets, such as Brazil, South Africa, and Turkey.

Commodities are also a good barometer of the appetite for risk. Gold tends to hold its value whatever the outer market conditions, whereas silver tends to rise and fall in line with demand.

Copper is one of the world’s most used metals, as it is needed for both construction and manufacturing. Therefore, when the price of copper is rising, it is a good indication that the market is bullish and risk-tolerant. Conversely, a fall in the price of copper indicates an industrial slowdown, and risk-averse safe haven currencies rise in value.

Open interest

The Open interest refers to the number of open positions there are for each currency. This data is available on the futures exchange, and it can be a useful tool for gauging the future strength or weakness of a currency.

In summary

Sentiment analysis is a useful tool for helping you to identify when the market is about to turn. This will help you to define and manage your trading strategy.  However, it should just be one of several tools, and not used as the sole indicator to guide your trading decisions.  

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