Every trader will always have an opinion about the market.
“It’s a bear market, everything is going to hell!”
“Things are looking bright. I’m pretty bullish on the markets right now.”
Each and every trader will have their own personal explanation as to why the market is moving a certain way.
When trading, traders express this view in whatever trade he takes. But sometimes, no matter how convinced a trader is that the markets will move in a particular direction, and no matter how pretty all the trend lines line up, the trader may still end up losing.
A trader must realize that the overall market is a combination of all the views, ideas and opinions of all the participants in the market. That’s right… EVERYONE.
This combined feeling that market participants have is what we call market sentiment.
It is the dominating emotion or idea that the majority of the market feels best explains the current direction of the market.
How to Develop a Sentiment-Based Approach
As a trader, it is your job to gauge what the market is feeling. Are the indicators pointing towards bullish conditions? Are traders bearish on the economy? We can’t tell the market what we think it should do. But what we can do is react in response to what is happening in the markets.
Note that using the market sentiment approach doesn’t give a precise entry and exit for each trade. But don’t despair! Having a sentiment-based approach can help you decide whether you should go with the flow or not. Of course, you can always combine market sentiment analysis with technical and fundamental analysis to come up with better trade ideas.
In stocks and options, traders can look at volume traded as an indicator of sentiment. If a stock price has been rising, but volume is declining, it may signal that the market is overbought. Or if a declining stock suddenly reversed on high volume, it means the market sentiment may have changed from bearish to bullish.
Unfortunately, since the foreign exchange market is traded over-the-counter, it doesn’t have a centralized market. This means that the volume of each currency traded cannot be easily measured.
Without any tools to measure volume, how can a trader measure market sentiment?!
This is where the Commitment of Traders report comes in!