The sentiment is the emotional bias of the market and the feelings of the market participants can either be positive or negative towards a specific market. When markets transition from being bullish to being bearish and vice versa, it is due to the change in sentiment. During the transitions, the market will have points where the sentiment is at its optimistic extreme or the pessimistic extreme. It has been largely argued that the traders and investors that exclude crowd psychology from their models are bound to fail. Economic indicators cannot solely serve as the basis of market movements, because in some cases the market reacts in contrast to what is suggested by economic data.
All seasoned traders and those who have been in the markets can agree that there was an instance in their trading journey when markets rallied euphorically above their intrinsic value, and this tells us that the theory of market efficiency is not always applicable to the markets. Even though sometimes the economic releases are rightfully reacted to, the mere fact that it is not at all times makes the relationship between the market and economic data inconsistent. Most traders pay much attention to economic indicators regardless of the inconsistency and this is because it's in human nature to go with the crowd. It is much easier to be incorrect with the crowd than to be wrong alone.
The herd mentality is not limited to real-life situations only but it also applies to all kinds of markets. The efficient market hypothesis states that the market would be at equilibrium until demand exceeds supply or vice versa, and the markets will seek another level of equilibrium after an imbalance. Although, in reality, that is not usually the case. Generally, traders and investors should buy a currency of a country that has good economic data and would sell currencies of a country that has poor economical data, this kind of model is objective but traders are emotional and subjective. This is the reason you will find the currency appreciating from a bad economic release or depreciating from good news.
This article is not suggesting the abandoning of economic indicators it would be ideal for a trader to know when data is released because they result in a lot of volatility. Most of the time it's profitable to fade the euphoric moves that usually happen after a release. For example, if you have a bullish sentiment on Euro/USD, and after the news release the Euro/USD sells to a resistance level this can be a great opportunity to go long the greenback. This article is an attempt to show that herd mentality in the forex market is evident and how one can take advantage of it. The demand and supply theory states that demand will increase as price moves lower, but the market's buyers tend to buy an instrument when the price goes higher and this reflects the irrationality of market participants.
It would be rational for traders to buy at lower prices and sell at higher prices, but traders do the opposite and that is the reason the majority of traders are unable to be consistently profitable. If you are not preparing for trades then prepare to fail because all successful events have great preparation behind the scenes. Traders in forex markets need to have a plan of approach to the market and refrain from taking economic indicators as factors in deciding whether to go long or short. You have probably realized by now that this article does not advise the reliability of economic indicators as the reason to buy or sell, but this article advises traders to take a more technical point of view.
Trading is not as simple as buying when the RSI is oversold or selling when the RSI is overbought, but if a trader seeks to gauge the sentiment of the market they are more likely to survive and thrive in the market. The trader can use the top-down analysis to acquire information from the market and when conducting this analysis the market participant needs to know how the big market participants are positioned. This information can be gathered on the CFTC's website. The Cftc report provides information on how institutional investors are placing their trades. The Cftc reports show us that speculators are always extremely long at market tops and extremely short at market bottoms, and institutional investors are always counter-trending.
The reason the large traders are counter-trending is that they are not seeking to generate profits but are rather hedging. Knowing about this relationship will give the trader an urge since market extremes will be signaled by the report. After getting the sentimental view of the large institutions it would be time to utilize your understanding of market structure to assess the risk and time of your trades. Today's markets are dominated by fundamental and technical traders, and those who use both can be classified as sentiment traders, provided they don't rely on one type of analysis. The reason this article encourages minimum utilization of fundamentals analysis is that it's backward-looking and is not have much use in using in forecasting future movements.
Most new traders tend to perceive fundamentals as being the Holy grail of analysis, but that makes sense because of the crowd mentality that was explained previously. In forex, the conventional belief that going with the crowd is profitable does not apply because of the proven historical inconsistency between the market and economic indicators. The study of crowd psychology can be considered more valuable than studying economic indicators, especially in the markets like Forex, which consists of a lot of spectators. The NFP is an economic indicator that is released on Friday of the first week every month and provides one of the exciting days to trade.
This makes sense because a country that is unable to create jobs for its citizens will experience depreciation in discretionary income, which in turn will decrease spending, and businesses will have to cut workers due to less profit and this will result in an economic downturn. Therefore, it would be rational to believe that a good NFP number would increase the value of the dollar index but since market participants are emotional it could get us into trouble if we believe that with certainty. Looking at the headline of financial news can provide information about the sentiment of the market. Good headlines are mostly followed by a bear market and bad news tends to initiate a rally. Now it's time to take all the advice in this article and capitalize on them. Thanks for reading and good luck.